The Role of ETFs in a Sustainable Portfolio

2020-05-19

The SFi Product Spotlight Series is an accessible overview of the available sustainable investing toolkit. This first installment reviews ESG ETFs, which we recognise as a valuable building block of a 100% sustainable portfolio. In this overview, we highlight the importance of maintaining an intentional impact strategy even within a passive investment framework.

Sustainable finance enthusiasts have been quick to celebrate the outperformance of ESG ETFs in the recent market volatility – this is not only due to the catastrophic performance of oil & gas stocks over the period, which benefited low-carbon or fossil free portfolios, but also cushioned by more supportive fund flows, which is testament to the resilience of the movement. With this key win in the bag, there is no doubt that interest in ESG, especially in ESG ETFs, will continue its exponential growth in the coming years.

Dissecting ESG Outperformance

Based on feedback from the SFi Investor Circle, we have seen outperformance for certain ESG strategies:

RS Group has shared that their ESG bank mandates have shown clear outperformance (+3% vs benchmark) in the first quarter of 2020. This is attributed not only to their explicit fossil fuel-free mandate, but also because the best-in-class approach leads to sector overweight in Healthcare, Tech, Consumer Staples, which have outperformed; in general, the focus Quality factors such as strong cashflows and balance sheets also contribute to resilience.

On the other hand, Huey Ko has seen mixed performance in equities depending on strategy; for example, one engagement fund saw a greater drawdown than her other ESG funds. She surmised that it could be due to the fund’s focus on small- and mid-cap companies with potential to improve on ESG metrics. With its strategic focus on longer term valuation enhancement and impact additionality, it is perhaps less meaningful to compare its performance with other funds over the short term.

Meanwhile, Huey also shared that both green and sustainable bonds within her bank mandate have held up well, with less volatility. Our industry checks also support this picture, with credit investors sharing that, although liquidity was similarly challenged for green and “brown” (conventional) bonds, a lot of green bonds became bid-only and did not see significant sell flow.

Of course, as a longer-term commitment, the value of a coherent sustainable investing strategy should not be judged by financial performance in one quarter. Additionally, as illustrated above, the choice of strategy will have an impact on financial risk/return – this applies not only to active investments, but for passive too.

For example, the following chart compares the performance of three global iShares ESG ETFs with their MSCI World offering:

Source: Financial Times

In this discussion piece, we hope to provide an overview of factors to consider in deciding to implement sustainable investing through ETFs, as well as potential ways to manage these factors and maximise your impact.

Accessibility – the undeniable appeal of passive investing

In many ways, the option of investing in ESG ETFs is a game changer that has enabled sustainable investing at scale for the masses – Morningstar estimates the size of the ESG ETF market to have surpassed US$100B in 2018.

The core driver of this success is, simply, accessibility. With low fees and entry/exit requirements, ETFs offer flexible ways to gain diversified exposure in desired markets with minimum effort. With the proliferation of available options over the past decade, ETFs have liberalised market access for everyday retail investors. This is especially relevant for the rapidly growing, but still niche, area of sustainable investing – with the field being relatively young, and as ESG investment strategies continue to evolve, most active ESG funds lack the accessibility, scale or track record to cater to the mass market. In Hong Kong. For example, among the 439 constituent funds on the Mandatory Provident Fund platform, only one has explicit ESG elements. Meanwhile, those seeking access to ESG can easily tap into a global trading account, giving access to over 250 ESG ETFs.

This accessibility has been instrumental in enabling mainstream retail investors to build sustainable finance exposure, and remains a critical piece for a beginning portfolio, or as a risk management toolkit in a diversified sustainable portfolio. As investors continue to deepen their sustainable investing journey, however, we see limitations of a passive-only strategy.

How are ESG Factors represented in ETFs?

The following diagram from PRI explains the typical construction methodology of an ESG index:

The starting point for all ESG indices is screening – traditionally, the screening mainly excludes companies with business involvement in certain sectors, e.g. tobacco, firearms, gambling, or fossil fuels, based on the premise of the index. In Europe, screening approaches account for Eur15tr of assets. These exclusion indices are the longest standing approach within sustainable finance, but performance has not been convincing in the past decades.

This has fueled the rise in integrated approaches, whereby the screening is conducted based on ESG ratings, allowing investors to invest on relative ESG merits of different companies.

Both of the above approaches would also be subject to adjustments to limit tracking error and maintain balanced market exposure. Nonetheless, a study from Schroders in 2019 has shown that most ESG ETFs are skewed towards certain sectors, and to larger companies which may better afford disclosures.

Finally, a more niche area is in so-called impact indices, whereby the screening is “positive” – companies are selected based on their revenue exposure to certain thematic priorities or goals. An example is the MSCI ACWI Sustainable Impact index, which selects companies based on alignment to the UN SDGs. This index is made up of only 122 stocks vs the ACWI’s 3,047, and is much more skewed towards smaller-sized companies.

They may also be customisable, so the investor would be able to select relevant goals to be represented in their passive strategy. An example is the service offered by OpenInvest, which screens companies across 16 “causes” which investors can invest in.

In general, these impact indices would have a high tracking error relative to a typical benchmark index, i.e. carry significantly higher risk. The value offering is somewhat different – moving away from the “buying the market” argument, and focusing squarely on accessibility alone.

But who will guard the guardians?

Despite the innovative development of better-aligned index methodologies, the available ESG ETF toolkit remains vulnerable to some key drawbacks. The first, and most fundamental, issue with sustainable investing through ETFs is – who decides on ESG ratings? With most “integration” strategies relying on ESG scoring and ratings, the implications of this question has only gone up in recent years.

This study from MIT Sloan, published last year, uncovers the large and significant differences between different rating agencies’ methodologies – the correlation among the top 5 ESG rating agencies’ ratings sits at just 0.61 on average, whilst in comparison there is 0.99 correlation among credit rating agencies. The discrepancy is attributed to differences in:

• Measurement – using different indicators as proxy for the same ESG attribute; this accounts for 53% of discrepancies;

• Scope – different attributes included in the same ESG value; e.g. inclusion of lobbying activities; accounting for 44%; and

• Weight – different weight is appropriated for underlying ESG factor components; accounting for 3%.

The following diagram illustrates the correlation across different factors, where interestingly, raters seem to disagree most on governance related attributes.

As the breakdown of the discrepancies imply, much of the divergence in opinions is down to definitions. The effects of this are proliferate – Morningstar recently reported that 60% of ex-fossil fuel funds in Europe do, in fact, have some fossil fuel exposure, due to differing definitions and scope (e.g. fossil fuels in reserves). The simple explanation is that, unlike factual, quantitative information such as market capitalization and liquidity, many ESG factors may be qualitative in nature. As such, it is difficult to eliminate bias of analysts and raters.

This does not mean it’s impossible – multilateral bodies such as the UN, IFC and WEF have all attempted to introduce unifying standards in recent years, but with the industry’s rapid growth the sheer number of new strategies and people also make it tough to arrive at a consensus.

The breadth of options presents a very “human” choice for investors, in ways that a simple index tracker may not be able to solve. ESG ratings are only one, among many, inputs that active investment managers consider, and most use a combination for cross reference.

Impact is a personal choice

Part of the issue with arriving at a common definition is that impact is a very personal choice to most people. Investing in “best-in-class” companies, for example, may be a way to drive strategic change for some investors, even if this means their portfolio would have exposure to utility companies that still use coal (but are actively transitioning).

For wealth owners, investing in an active manager could open up such discussions, and offer the potential to customise your investment impact through segregated accounts, and in some cases, funds could also publish customized impact reports – although all of this obviously comes with a cost.

In any case, this illustrates why it is especially important for investors who choose a passive strategy to research and build an intentional strategy around impact.

Deciding your personal definition of impact ahead of investment would ensure better expectations alignment.

Passive investments can be active, too

Much of this article has focused on the selection of the investment universe through indices, but that is only the first part of the puzzle. Whilst in normal ETF investing, most investors can select fund managers simply based on the ETF’s performance relative to the index, as well as other execution considerations such as liquidity and ETF premium/discount, in the realm of sustainable finance it is also crucial to demand responsible ownership.

There are challenges to active ownership practices in passive investing, most significantly given the constraint on divestment (i.e. there is no “teeth” even if engagement is unsuccessful) and stock lending practices (passive funds receive significant income from lending out positions, therefore foregoing voting rights). At the most basic level, however, equity positions carry voting rights regardless of whether they were acquired through active decision or index selection.

Vanguard, Blackrock and State Street, who command around 80% of global passive assets under management, are all PRI signatories who commit to active ownership standards, and have dedicated staff for engagement and proxy voting. This is not necessarily the end of this road, though – for example, this 2019 study challenges Blackrock and Vanguard’s voting history, alleging that they overwhelmingly supported management of fossil fuel companies, blocked climate-critical resolutions, and voted against proposals under the Climate Action 100+ investor coalition.

Studies like these have already pressured Blackrock into a more proactive stance – recognising investors’ influence, and yielding it to maximise impact, could drive real change.

Making the most out of your ETFs

Acknowledging the aforementioned areas of consideration, investors may consider the following process in developing an effective passive ESG strategy, for investors who prefer this approach:

Last but not least, for investors who truly believe in maximising their impact, understanding the limits of what a passive ESG ETF can and cannot advance is important. For SFi, we recognize the value of ESG ETFs as part of the investor toolkit, especially within a 100% sustainable portfolio. Its scale and accessibility make them an attractive option as a risk management allocation to balance more intentional impact strategies, for example in private investments. Ensuring that even passive investments, or risk management tools, are impact-aligned with overall portfolio objectives would be an important piece of the puzzle.

DISCLAIMER:

Sustainable Finance Initiative (SFi) is not an investment advisor. The content of this presentation is not intended and should not be used or construed as an offer to sell, or a solicitation of any offer to buy, any securities or other investment products in any jurisdiction. The content of this presentation is for information purpose only, and not intended and should not be construed as investment, tax, legal, financial or other advice.

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