Mega-trends

Are names, labels and ratings enough when it comes to ESG selection?

The number of environmental, social and governance or sustainability focused ETFs has grown dramatically in the past two years, making it difficult to chose the right one. But there is a way.

In 2019, only 10 per cent of flows into European ETFs were into funds with ESG or sustainability characteristics, but by 2021 that percentage had grown to more than 50 per cent – a dramatic change. The number of ESG-focused ETFs has also more than doubled, according to Morningstar, with more than 900 available globally in early 2022 compared to around 370 at the end of 2019.

Choice is good, especially in a market where investors have a range of values and priorities. However, we’re then presented with the challenge of how to choose.

Fund names are not always helpful. Even once you have decoded them, acronyms like ESG or SRI do not tell you much and do not always mean the same thing from one ETF to another. Terms like 'responsible' and 'sustainable' are equally hard to pin down. Across Europe, there are also multiple fund labelling schemes with different criteria.

The good news is that things are changing. Regulators in the UK and the EU are working hard to provide greater clarity about what counts as a sustainable investment and what information funds should provide to back up their sustainability claims.

However, these regulations, including the EU's Sustainable Finance Disclosure Regulations and the UK’s upcoming Sustainable Disclosure Requirements, are inevitably complex. It will take time for them to bed in and become genuinely useful to investors.

In the meantime, here are a few things to bear in mind when evaluating and selecting sustainable ETFs.

Transparency and sustainability go hand in hand

By their nature, ETFs are transparent. As they are predominately passive, advisers and investors can easily view not just the holdings but also the set of rules that drive their selection (ie the index methodology).

While active funds may have very well-defined investment policies, the rules-based approach of most ETFs is far more precise. For example, the fund might use ESG ratings, greenhouse gas emissions or screens for certain business activities. The index rules will specify where this data comes from, how it is used to select and/or weight securities, and how often data and holdings are refreshed.

For example, the index might include only companies with an MSCI ESG rating of A or better, or it might exclude companies deriving more than 5 per cent of revenues from fossil fuels. Constituents could be weighted by market capitalisation, or perhaps 'tilted' using a combination of marketing capitalisation and ESG ratings.

The index rules will also detail how often ESG data and holdings are refreshed. With sustainable and ESG funds, there are many possible approaches, using different data providers and different methodologies. In a passive fund following strict index rules, you know exactly what is going on.

While index methodologies can be unwieldy, they are also useful to gauge if an ETF meets a clients’ sustainable investment objectives.

Avoiding nasty surprises

No one likes finding a rotten apple in their fruit bowl. In investment terms, this equates to finding a company in your portfolio that does not match your values.

We frequently see headlines expressing surprise that a so-called ESG or sustainable fund could include, for example, a fossil fuel company. Given the range of approaches to sustainable investing, it is likely that some funds will include companies that others will exclude, and vice versa.

For example, some funds might be focused on active engagement with fossil fuel companies to drive change, while others prefer to exclude them completely.

The problem is not so much the different approaches, both could have value and one might be more effective than the other for certain asset classes, fund types and sectors. The problem is more the surprise when certain companies are included or excluded because the details of the approach were not clear. 

The same goes for wider indices. This month Tesla was removed from the S&P 500 ESG index, while oil companies like Exxon are still in there. This might come as a shock for some, but it is quite clear why Tesla was excluded according to others – it doesn’t have a low carbon strategy and has questionable labour practices. These give it a lower ESG score and are fairly standard measures in the world of ESG screening.

"It should be noted that Tesla hasn’t gotten 'worse' from an ESG perspective, according to S&P Dow Jones indices, it’s that everyone else is getting better. So, Tesla has fallen out the index due to its relative ESG score," says Hector McNeil, co-chief executive and founder of HANetf.

"If Tesla improves on these fronts perhaps it will be re-added. We should expect companies to come in and out of ESG indices as each company makes progress at different pace."

But because ETFs typically follow precise rules, you can check that a fund is applying the screens you care about. These could include broad exclusions like violation of the UN Global Compact (a set of principles covering human rights, labour, the environment and anti-corruption), controversial weapons or thermal coal.

However, it could also include a longer list such as alcohol, gambling, pornography and specific religious exclusions. But be sure to check the small print (ie the detailed index rules) because there are different ways to measure these things. For example, one fund might exclude companies with any involvement in thermal coal, while another might exclude only those with more than 5 per cent of revenues derived from thermal coal.

Also be aware that there can be a degree of subjectivity, particularly when it comes to timing. For example, most ESG data providers gave Volkswagen a red flag following their emissions fraud in 2015. However, there was significant variation in when the company was deemed to have taken sufficient action to resolve the issue and the red flag was removed.

All investors can align with Paris climate goals

Climate change is the overarching issue of our time, but there is a perception that investors can only contribute via specialist climate funds, such as clean energy or green bonds ETFs.

It is important to channel assets into these funds to help fund the solutions and technologies we need to address climate change. However, because of their narrow focus, these funds may have concentrated portfolios and could potentially have high volatility. For most investors, they make sense as smaller, satellite allocations rather than core holdings.

The reality is that the majority of client assets are in core allocations and cannot be exposed to excessive risk. Does that mean that these funds cannot contribute in some way to solving the climate crisis? Could these large pools of assets at least be channelled into more 'climate-friendly' investments, while still meeting the requirements for core holdings?

A relatively new solution has emerged in the form of the EU climate benchmarks, a set of rules designed to help investors reallocate capital towards a low carbon economy and align portfolios with the Paris climate goals of limiting global warming to 2C and preferably 1.5C.

The EU has defined two types of benchmark:

• Paris-aligned benchmarks (PAB) must reduce greenhouse gas emissions by 50 per cent compared to the broader market and by 7 per cent each year. They also exclude companies deriving a certain percentage of revenues from fossils fuels and energy-intensive electricity generation.
• Climate transition benchmarks (CTB) must reduce greenhouse gas emissions by 30 per cent compared to the broader market and by 7 per cent each year.

Both benchmarks also apply important ESG screens, excluding issuers violating social norms like the UN Global Conflict, causing significant environmental harm or involved with controversial weapons or tobacco. In essence, PABs can be seen as investing in the economy of tomorrow, while CTBs reflect an economy in transition.

'Low carbon' ETFs are not new. However, the PAB and CTB rules ensure a consistent minimum standard and alignment with the Paris goals. Importantly, they can be applied to almost any asset class and allow broad exposure, suitable for core allocations. For example, Tabula has launched Paris-aligned ETFs covering both the Euro Investment Grade and the Euro High Yield bond markets, both providing well-diversified exposure.

Performance can be a red herring

The adage that past performance is not a guide to future performance is particularly apt for sustainable investments. Many of the risk, opportunities and impacts that they address are in the future not the past and are long-term rather than short-term.

Much is made of the outperformance of ESG funds, for example in the early stages of the Covid-19 pandemic. However, short-term differences between ESG and non-ESG ETFs are often due to sectoral trends that are not ESG-driven. For example, the collapse in energy stocks in early 2020 was more due to a rapid global slowdown than any sudden repricing of climate risk. So, ETFs that excluded fossil fuel companies did outperform, but perhaps not for an ESG-specific reason.

However, over the longer term, these stocks could suffer if they do not adapt to a low carbon economy. Instead of focusing on short-term performance, the key is to understand an ETF’s risk/reward profile and how it might differ from traditional benchmarks.

Paris-aligned ETFs make an interesting example. Currently, these have lower exposure to carbon-intensive companies and exclude many energy companies because of their fossil fuel exposure. They provide diverse exposure but could differ from traditional tracker funds if particular companies under or outperform. However, in future, if the wider economy adapts and decarbonises, then traditional trackers will evolve to become more similar to Paris-aligned ETFs.

If the wider economy does not adapt, then the two products could diverge further, perhaps exposing traditional tracker funds to a greater degree of climate risk.

Do not leave out half the portfolio

Sustainable and ESG-focused ETFs focused initially on the equity market. However, fixed income is a huge proportion of global assets and the range of ETFs is growing fast.

There is now a selection of Paris-aligned bond ETFs for core allocations, green bond ETFs for more specialist exposure and no reason not to shift bond assets towards the new low carbon economy.

Michael John Lytle is chief exeuctive of Tabula Investment Management