ESG interest drives ETF expansion in Europe

The European exchange-traded funds industry — predominantly an institutional investor business in the region — is developing at a fast pace, as the pandemic and interest in ESG-specific products in particular accelerate interest.

In stark contrast to the U.S., institutional investment in ETFs outstrips retail interest in Europe. Sources estimate the institutional-retail split for the $1.37 trillion European ETFs market to be about 80-20.

But rather than simply investing in ETF products developed by providers, "in recent years we've seen many partnerships between ETF issuers and institutional clients with new launches seeded with multiple hundreds of millions of dollars," Matthew Tagliani, London-based head of ETF product and sales strategy for Europe, the Middle East and Africa at Invesco Ltd., said in an email. The firm has more than $53 billion in ETF AUM in Europe.

Two such institutional investors can be found in Finland — and they're both focusing on environmental, social and governance ETFs.

The most recent investment was by Varma Mutual Insurance Pension Co., Helsinki, which was an anchor investor in BlackRock Inc.'s U.S. Carbon Transition Readiness ETF, launched April 8. Varma invested €200 million ($240 million) in the sustainable ETF.

The €52.9 billion fund has not only been the anchor investor on new offerings, but in 2019 created its first ESG ETF.

It helped to create a responsible investment-focused European equities ETF with Legal & General Investment Management Ltd. and investment services provider Foxberry Ltd., investing €200 million. The L&G Europe Equity (Responsible Exclusions) ETF was listed on the London Stock Exchange in September. Later in 2019, Varma worked with the same two firms to create a responsible invest-ment-focused U.S. equities ETF, investing €500 million in the L&G U.S. Equity (Responsible Exclusions) UCITS ETF.

Varma's total exposure to ETFs amounts to "a meaningful number," Timo Sallinen, head of listed securities, said in an email. He did not give an exact figure.

Mr. Sallinen added that ETFs are a "very flexible way to take exposure and reduce it," and that executives will continue to invest in the products in the future. "Seeding new ESG ETFs are possible," he added.

And fellow Helsinki-based fund Ilmarinen Mutual Pension Insurance Co. had €5.2 billion invested in equity ETFs — 9.7% of total assets and 27% of its equity exposure, Juha Venalainen, senior portfolio manager, cross asset allocation, said in an email.

The fund has used ETFs for years, but in 2018 began a process of aligning its passive portfolio with its ESG objectives.

"The indirect exposure from broad-index ETFs to controversial industries and companies" led executives to "think about the ways of filtering our passive exposure," Mr. Venalainen said. It asked providers to create ESG ETFs based on the MSCI ESG Leaders indexes and now more than 90% of its ETFs exposure is invested in ESG products.

Ilmarinen's latest venture saw it invest €500 million in the Amundi MSCI Emerging ESG Leaders UCITS ETF, listed on Germany's Xetra trading venue in June. The ETF marked the fifth listed index fund that invests in an ESG index that was co-developed by Ilmarinen, the fund said in a news release at the time.

"ETFs are excellent products to diversify equity exposure cheaply and transparently to chosen markets, sectors or themes," Mr. Venalainen added.

ESG-focused ETFs are driving growth of the European market in 2021, following a strong 2020. Morningstar Inc. data show ESG ETFs gathered €25.8 billion of inflows in the first quarter, accounting for 54% of total investments in ETFs. ESG ETFs assets under management totaled €117.9 billion as of March 31, up from €87 billion as of Dec. 31, and represent 10.2% of total assets invested in ETFs in the region.

Research by Lyxor Asset Management showed ESG ETFs attracted €45.5 billion in assets in 2020, accounting for 51% of total inflows and twice the amount of assets raised in 2019.

ESG "is obviously where two trends merge: the ESG trend is the trend of the hour and also drives ETFs now. But I would not say it is an ETF trend — it is an industrywide trend that has now come to ETFs and passive mandates as well," said Christian Zahn, partner and co-leader of the European asset and wealth management practice at McKinsey & Co. in Frankfurt.

Providers agreed that ESG has helped drive ETF sales over recent times. Mr. Tagliani acknowledged that institutional demand for ESG was one of the drivers in the market, as did Brett Pybus, managing director, head of iShares investment and product strategy in EMEA at BlackRock.

"ETFs integrating ESG criteria (is) making sustainable investing more accessible to investors," he said in an emailed comment.

Providers also think ESG will continue to be a driver for ETFs for three reasons, said Matthieu Guignard, Paris-based global head of product development and capital markets, Amundi ETF, indexing and smart beta. "The pandemic crisis has reinforced investors' willingness to shift toward more ESG friendly solutions. In our view, the COVID-19 crisis has accelerated a pre-existing and long-term trend within the investing world," he said.

The second reason is that the election of Joe Biden as U.S. president "brings new hope for the global fight against climate change and for climate advocacy," while the third is that the European Union's Sustainable Finance Disclosure Regulation, which came into force in March, requires greater transparency on the degree of sustainability of financial products, he said. Amundi, which struck a deal last month to acquire Lyxor Asset Management mainly to increase expertise in the ETFs market, had €77 billion in exchange-traded products AUM as of March 31.

But there's also another investment-type factor at play: Fixed-income ETFs are "serving as a modernization force for the $100 trillion bond market," Mr. Pybus said.

Fixed-income ETFs in particular showed resilience amid market volatility in March 2020, sources said.

"The past decade, equity products really drove growth," said Matteo Andreetto, London-based head of State Street Global Advisors' SPDR ETF business for EMEA. "However, more recently fixed income has been accelerating — the use of fixed-income ETFs by large pension funds has developed the past 18 months and significantly accelerated during COVID."

Fixed-income ETFs pulled in €36.9 billion in 2020, according to Morningstar Inc. data, gathering €23.3 billion in the second quarter of 2020, immediately following the height of the coronavirus pandemic. That represented 70% of total ETF flows in Europe for the quarter and followed €13 billion in net outflows for fixed-income ETFs in the first quarter.

What really stood out was the third week of March 2020, when "everything was down 5% or more including sterling — in moments of crazy liquidations and needs of liquidity in the market, the ETF market especially in UCITS was also put to the test. Was liquidity really going to be accessible in the form of an ETF and adding in the potential volatility to overall markets, how is this going to work? What we have seen is that not only ETFs have passed that exam, but with an A+ because there was no disruption in the market, no failed trades, everything worked as it was supposed to and ETFs really functioned as a fully funded mini future — especially in fixed income," Mr. Andreetto said.

Others agreed. "From what I observed, liquidity seems not to have been a big issue — there were no huge challenges (amid the COVID-19 pandemic). That was good news for the industry, and also the fact that ETFs had substantial inflows in this difficult year showed investors seem to be happy with the concept," McKinsey's Achim Schlitter, senior knowledge expert in Frankfurt, said. Overall, European ETFs attracted €102.7 billion in net inflows in 2020, according to Morningstar.

ETFs were the "real heroes of the crisis in the financial industry," said Andreas Zingg, head of Switzerland and Liechtenstein and managing officer based in Zurich at Vanguard Group Inc. Mr. Zingg said he was paraphrasing Vanguard CEO Mortimer "Tim" Buckley, referring to a situation where "actually liquidity was very challenging and (ETFs) delivered exactly what they should deliver," Mr. Zingg said. Vanguard runs almost $80 billion in ETF assets in Europe with 27 products.