[This article appears in our April 2021 issue of ETF Report.]
Environmental, social and governance exchange-traded funds are rising with regard to both the number of available products and the amount of assets under management, so it’s no surprise to see ETF issuers launch ESG funds applying the relatively new actively managed nontransparent structure.
Actively managed, nontransparent exchange-traded funds debuted in 2020. In this new structure, fund issuers don’t need to disclose holdings daily, jettisoning one of the hallmarks of ETFs: transparency.
Reduced transparency may not matter for some funds, such as the T. Rowe Price Blue Chip Growth ETF (TCHP), an ETF version of a well-known mutual fund. But transparency is the point for ESG funds. Socially responsible investors want their investments to line up with their values. Given the lack of transparency, will ESG investors want these funds?
American Century and Invesco are the first fund families making a foray into the nontransparent ESG ETF space. The American Century Sustainable Equity ETF (ESGA), is a U.S. large cap, nontransparent ESG ETF released in July 2020, similar to the firm’s nearly 16-year-old mutual fund, the Sustainable Equity Fund. Meanwhile, Invesco released in December both the Invesco US Large Cap Core ESG ETF (IVLC) and the Invesco Real Assets ESG ETF (IVRA).
Both of the firms use a proxy basket to give investors insight into the value of underlying assets, but without disclosing daily the holdings. American Century uses the NYSE proxy structure, while Invesco uses a proprietary model.
Ed Rosenberg, head of exchange-traded funds for American Century Investments, likes the proxy basket structure for ESG funds because investors can compare the quarterly holdings, or at least the monthly top 10 holdings, to get an idea of how much has changed, even if not all of the holdings are visible.
“It gives the investor an option to say, ‘OK, their philosophy still seems to be holding course, because I can see the holdings on the 28th of the month,’” he said.
Anna Paglia, head of ETFs and indexed strategies at Invesco, explains this is the first time Invesco brought ESG screening to active ETFs. These aren’t brand new strategies, but they’re an “evolution of existing strategies with a proven track record. They’ve been adapted so that they’re more concentrated versions of existing mutual funds.”
The two ESG funds are among four that Invesco launched using the new nontransparent structure, which the firm believes will have a strong future. “It brings together security selection, and we eliminated the risk of front-running with the cost effectiveness and the tax efficiency of ETF technology,” Paglia explained.
Invesco is prepared to dedicate time to the new structure, she adds: “Nontransparent ETFs won’t be an overnight success story, but will take a lot of education and training to make financial advisors comfortable with the strategies.”
Will Return Offset Transparency?
Amrita Nandakumar, president of Vident Investment Advisory, is intrigued by the nontransparent ESG ETF concept. Even though ESG investing started with mutual funds, where investors are used to little transparency, Nandakumar notes ETF investors have a certain set of expectations about their ETF, and full transparency is at the top of that list.
Active funds in general seek to generate outperformance, but she wonders if ESG investors would be willing to give up some transparency in order to get potential outperformance.
“Now, part of that question, I guess, depends on what the investor is trying to outperform,” Nandakumar said. “Are you trying to outperform a transparent, active ESG strategy, or an indexed one? Either way, it’s a little too soon to say, but I’m really curious to find out.”
Ben Johnson, director of global exchange-traded fund research for Morningstar, thinks the lack of transparency isn’t a big deal, calling it “much ado about nothing.”
He explains that investors need to look at the concept of transparency in the ETF structure and ESG separately.
“I don’t think there’s anything in any way potentially nefarious within the structure that would be at odds with the values and the goals of an investor who’s selecting an ESG-intentional fund for very specific, very personal reasons,” he said.
These managers are “really every bit as transparent as they care to be on any given day,” he remarked, noting the managers may show incrementally less on trading days to shield those trades from negative market impact.
ESG investors are squarely focused on the strategy and the transparency around the process, as opposed to the wrapper, Johnson suggests.
Taking ESG Seriously
American Century’s Rosenberg explains ESG is at the core of the firm, since 42.5% of the firm is owned by the biomedical research organization Stowers Institute for Medical Research, which uses much of the firm’s profits to conduct basic research on genes and proteins for disease prevention and treatment.
The ESGA exchange-traded fund focuses on companies that American Century believes have improving business fundamentals and sustainable corporate behaviors. While it uses a common exclusionary screen to weed out “sin” stocks, the fund is otherwise inclusionary, he says. They use third-party data and have an in-house ESG team to analyze securities.
Glen Yelton, head of ESG, North America at Invesco, explains the firm has an in-house ESG team of 13 people who use internal research on sector materiality and external data for analysis, and apply exclusionary screens.
Which screens matter most depend on the fund, he points out, noting a tobacco screen is more relevant for IVLC, the large cap core fund, versus IVRA, which invests in real estate, infrastructure, natural resources and timber assets that meet Invesco’s proprietary ESG standards.
Invesco takes a spectrum approach to ESG, starting with exclusionary screens at a minimum up to impact investing, the most rigorous of ESG investing because of its ongoing reporting and measurement, Yelton explains. Both American Century and Invesco say they’re active in voting proxies with ESG in mind, something that may mitigate any perceived drawbacks around lack of transparency.
Who’s Buying These Funds?
Nontransparent funds as a whole are relatively new, and Morningstar’s Johnson observes there’s been a lukewarm response: “The natural kind of investors in these funds are going to be those who know the strategy well, know the managers well and have, for whatever reason, incremental dollars in a taxable setting that they need to invest.”
Peter Krull, CEO and director of investments at Earth Equity Advisors, is leery of nontransparent ESG ETFs, noting that many of the most popular ESG ETFs have only basic definitions.
“Even before we get into these nontransparent ETFs, people don’t know what’s inside the [transparent] funds. My favorite whipping boy for this is the iShares ESG Aware Fund (ESGU), which is just horrible, but it’s got $13 billion in AUM. It’s the fastest-growing of the bunch, and it [holds] Exxon and Chevron,” he said.
Krull isn’t opposed to actively managed transparent ESG ETFs. He notes that his firm uses the First Trust NASDAQ Clean Edge Green Energy Index Fund (QCLN), and regularly monitors holdings for any changes that might not be in line with the firm’s sustainability strategy despite the fact that it’s a passively managed ETF.
Clint Walkner, founding partner and financial advisor at Walkner Condon Financial Advisors, whose firm works with clients interested in ESG investing, is “intrigued” by IVRA, pointing out the dearth of choices for alternative asset classes using ESG, especially in infrastructure and natural resources sectors. But his interest is more in the ETF’s holdings versus the fund’s structure.
“While I think some funds may benefit from the nontransparent structure, I don’t see a big advantage for IVRA,” he said.
As this issue was going to print, Stance Capital launched its own actively managed ESG ETF. The Stance Equity ESG Large Cap Core ETF (STNC) relies on the Blue Tractor model for nontransparent ETFs, which publishes the full holdings daily but with altered weights. For ESG investors, that means they can at least see what they’re holding at any time, even if they don’t know the weightings.