ESG A Growing ETF Phenomenon

[This article appears in our April 2021 issue of ETF Report.]

Environmental, social and governance investing has been popular with institutions and certain niche investors for years, but interest in ESG investing has ballooned beyond those groups.

US SIF, an organization that has tracked socially responsible investing since 1995, reported in November that 33% of total U.S.-domiciled assets under management (AUM) now use sustainable investing strategies.

One of the biggest ETFs in terms of AUM is an ESG fund, the $14.3 billion iShares ESG Aware MSCI USA ETF (ESGU), and the business world takes notice when BlackRock’s CEO, Larry Fink, issues an annual letter stating his firm’s views on ESG. This year, Fink is pushing other companies to set targets to be carbon neutral (“net-zero”) by 2050.

ESG investing considers financial return as well as social and environmental good, and interest has grown steadily over the past four to five years, particularly in regard to climate change. Darek Wojnar, head of funds and managed accounts at Northern Trust Asset Management, notes that accelerated in 2020.

“The whole COVID situation last year brought it to the forefront with understanding of various impacts on health measures, policy measures, climate change measures and social issues,” he said.

Moving To The Forefront
Beyond the pandemic, other events brought ESG investing into sharper focus. Last year’s killing of George Floyd and the rise of the Black Lives Matter movement sparked a renewed look at racial policies at some companies. Mismanaged community relations in Australia, where mining giant Rio Tinto blew up caves sacred to indigenous people, spotlighted failed social and governance policing, leading to the sacking of three C-suite executives.

ESG is finding its way into fixed income, too. Sustainable-debt issuance—including green and social bonds—reached a record $530 billion in 2020, according to Environmental Finance, up 63% from 2019.

William Sokol, ETF product manager for VanEck, remarks that figure is particularly impressive, because the debt market was nearly shuttered last March and April as the pandemic was ramping up.

Sustainable debt has more reporting and transparency requirements because these are linked to long-term projects, such as renewable energy for green bonds, or affordable housing for social bonds, and were initially shunned in a rush for cash.

With the Biden administration’s aggressive climate goals, ESG investments may grow further. But despite the headlines, is ESG really mainstream? Depends on who you ask.

Brian Haney, founder of financial services advisory The Haney Company, believes so, pointing to the US SIF data. He says advisors should embrace the concept: “ESG investments have measurable track records, and can and should be instruments people explore.”

But others say the newer ESG products are really ESG in name only if they don’t include shareholder engagement, something common with active management.

Jim Nadler, CEO of KBRA, a nationally recognized statistical ratings organization, says that much of the push into ESG by banks and fund managers comes from institutional stakeholders who want greater disclosures about factors that may affect a bond’s creditworthiness or stock price.

“Larry Fink is not out making statements … about climate change because he all of a sudden decided it was good for humanity. I think he probably believes that,” Nadler said. “But I also think he’s hearing from stakeholders.”

ESG is about risk management, Nadler observes. That can mean factoring in the future creditworthiness of a coastal municipality regarding the risks of rising sea levels, or how carbon emissions affect a company’s business model.

Watershed Moment
It’s not about telling people how to invest, but to understand material risks. Nadler gave a hypothetical situation about gun manufacturers, which are usually excluded from ESG funds. It’s possible that a judge links a mass shooting to a gun manufacturer. These makers could face monetary losses similar to the payouts tobacco firms had to make decades ago when smoking and cancer were linked.

“That is the watershed moment,” Nadler said. “It’s not that I want to push my preference on you, but I will give you all the facts as we know them that may make you think twice about investing.”

ESG is also about opportunity, notes Jean Boivin, head of the BlackRock Investment Institute. Ignoring climate change is an investment risk, but there are also opportunities for companies transitioning to a net-zero economy.

The Institute’s capital market assumptions forecast that if there’s an orderly transition to a net-zero-emissions world, it could result in a cumulative output gain of nearly 25%, with technology and health care benefiting above energy and utilities because of individual sectors’ climate risk.

Branching Out
Many ESG funds are still focused on U.S. or European large caps, but ESG is moving into other sectors, including emerging markets. Amit Anand, co-founder of NextFins, which launched the Nifty India Financials ETF (INDF), says emerging markets are prime candidates for ESG, especially for the social and governance pillars.

As an example, Anand notes that hundreds of millions of Indian citizens are rising out of poverty, helped by Indian banks that are providing online banking through smartphones, often to people who never had access to banking.

ESG in emerging markets has been mostly the purview of institutional traders investing in impact environmental projects, but it’s become easier for financial advisors and other investors to reach this sector. However, Anand cautions, possible ESG investors in emerging markets still need to be wary, and focus on high quality companies with strong governance policies.

Greenwashing Potential
Like other investing styles such as growth or value, there is no ESG-investing definition, and no uniform U.S. or global standards on what or how companies disclose information. That can make it confusing for investors wanting to pick funds.

“It’s true to say there is no real global set of standards when it comes to ESG and sustainability, either in the U.S. or anywhere else in the world. This can make it quite difficult for investors to really compare and contrast different funds, and to ultimately challenge the marketing and promotional aspects of particular products, making ‘greenwashing’ still a feature of our industry. However, the new EU disclosure regulations (SFDR) are intended to provide comparable information on funds, which should help,” said Will Oulton, head of global responsible investment at First Sentier Investors.

Oulton recommends investors use tools from Morningstar or MSCI to review ESG investments.

Some ESG participants say terms like “greenwashing” may be an overstatement if a fund family uses third-party ESG data from a well-established researcher to create an ESG ETF. The question is whether fund families—especially for index ESG funds—are voting proxies on ESG mandates or doing shareholder engagement, usually the purview of active managers who charge higher fees.

Changing Company Behavior
More funds may be managed according to some ESG criteria, but Hans-Christoph Hirt, an executive director and head of the stewardship team at global investment manager Federated Hermes, offers that “true” ESG funds are those in which ESG is imbedded throughout the company, and managers are actively engaging with companies to change behavior.

“I would say the ESG investing industry is relatively small, but many are jumping on the bandwagon,” he said.

To bring more clarity to investment funds, Chris Fidler, senior director of product management at the CFA Institute, says the organization is creating voluntary ESG disclosure standards for investment products.

The CFA Institute expects to release a draft of the standards in May. Fidler explains that the organization seeks to bring uniform transparency to a product’s ESG-related objectives, constraints, policies and methodologies.

“What we’re trying to do is to make sure the investors have the information they need to evaluate a manager’s claims about whether a product does or doesn’t do something, and to evaluate whether the product meets their needs and preferences,” Fidler said.