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A Due-Diligence Checklist for Choosing ESG ETFs

Questions to ask when picking exchange-traded funds with a sustainable focus

Hortense Bioy

 

The range of ETF options available to sustainability-oriented investors is growing. While this is great news for investors, it poses a due-diligence challenge.

The differences between the various offerings are becoming increasingly nuanced. In our recent paper, we explore key questions that investors should consider when choosing an ETF with a focus on environmental, social, and governance (ESG) factors.  

8 questions to ask when evaluating ESG ETFs

  1. What’s the fund’s ESG focus and the metrics it uses? An investor must first decide whether the focus of an ETF’s underlying index and the metrics it uses are aligned with the ESG criteria that he or she wishes to emphasize. For example, there are many environmental metrics—including carbon emission intensity, fossil fuel reserves, and green revenues. Different metrics reflect different company attributes, and the choice of one metric over another may lead to different fund composition.
  2. Does the fund apply exclusions? Many ESG ETFs use some sort of values- or norms-based exclusionary screening in addition to their consideration of ESG factors. Investors must evaluate whether an index’s exclusions, or lack thereof, align with their beliefs and investment objectives. Modern Portfolio Theory suggests that limiting the investment universe—especially when it’s done on a purely nonfinancial basis—forces an investor into a less-efficient portfolio that will have lower risk-adjusted performance than a more efficient portfolio selected from the broader universe. Note that some exclusions such as fossil fuels, coal, and possibly tobacco do have a financial basis, while others, like alcohol and gaming, do not.
  3. Are there any sector and geographic biases? ESG scores tend to vary across geographies and sectors. For example, Europe is the world's leading region for sustainability, while emerging markets tend to score poorly. Some sectors, such as oil and gas, are prone to low overall ESG scores. But others, such as technology, may have higher scores due to the nature of the underlying businesses. Sector and geographic biases can impact performance relative to the broader market.
  4. What’s the fund’s tracking error relative to the broad market? There’s a potential trade-off between high ESG scores on one hand, and broad diversification and low tracking error on the other. For example, those investors most committed to sustainability may favor the “purest” ESG exposure, but at the expense of a more concentrated portfolio with higher tracking error. Investors seeking to replace a core portfolio allocation may be more willing to compromise on the purity of ESG holdings (e.g. accept less compliant holdings) in exchange for retaining the benefits of diversification and lower tracking error. Optimization techniques can be used to minimize tracking error.
  5. Does the fund charge a sustainability premium? Fees charged by ESG ETFs are generally higher than those levied by their more ordinary passive peers. This is especially the case for some of the older funds and those that target specific themes.
  6. What’s the fund’s track record? Performance analysis can be a challenge as most of the newly launched ESG ETFs track indexes that have short track records. This means that a returns-based analysis must often rely on back tests, which can be manipulated, whether consciously or not, to achieve the desirable outcomes.
  7. Is the fund company a responsible steward? Investors should select responsible asset managers who vote company shares and engage with companies on a variety of ESG issues to advocate for better practices and effect change. Partnering with an asset manager that has strong active ownership practices is especially important when selecting funds that include, rather than exclude, sustainability laggards.
  8. How sustainable is the fund? It isn’t always easy for investors to objectively assess how sustainable an ESG ETF actually is and how it might compare to other choices in the market. To help investors understand the sustainability profiles of the funds they invest in, Morningstar created the Morningstar Sustainability Rating™ for funds. The rating assesses funds based on how well each of the companies they own live up to a set of defined ESG criteria.

Passive funds are making inroads into the market for sustainable funds

Our report further examines the global landscape of passive sustainable funds—looking at trends in asset growth, asset flows, product development, and fees on a region-by-region basis. We also discuss the broad range of approaches that address various sustainability and investment objectives.

Read the full research paper “Passive Sustainable Funds: The Global Landscape.”

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