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
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.
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.
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.
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.
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.
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
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.
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
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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