Demand for ESG means more decisions for investors

Long the domain of politically minded pension funds and mission-driven foundations, investing with a keen eye on climate risk is pushing through to the mainstream, bringing with it yet another series of decisions for exchange-traded fund investors to muddle through.

For years, ETFs focusing on environmental, social, and governance factors have been a backwater of the $4.5 trillion U.S. ETF market. But asset growth has been swift over the past year — more than $8 billion in net flows to top $22 billion in assets under management, according to research from XTF Inc. The bulk went to MSCI-indexed products from BlackRock Inc., while Vanguard Group attracted more than $1.2 billion to two FTSE-based index products launched in September 2018.

"Previously, many products were not that interesting to us, as they could have so many ESG layers that they were no longer tracking a more mainstream index and pricing was not competitive," said Anna Hyrske, head of responsible investments at Ilmarinen Mutual Pension Insurance Co. in Helsinki. "Now we see passive products following mainstream ESG indices with very competitive pricing."

At the end of the third quarter, €49.1 billion ($54.6 billion) Ilmarinen held roughly $2.6 billion in two products from BlackRock and DWS Group, both tracking the MSCI USA ESG Leaders index.

Yet as the burgeoning market struggles to define itself in the face of investor demand, the Securities and Exchange Commission is reportedly bearing down for clarity in marketing. In a speech before the American Enterprise Institute last June, SEC Commissioner Hester Peirce channeled her namesake and delivered a diatribe against those "scarlet letters" — E, S and G.

"Popular discourse has fueled the efforts of ESG instigators, which include developers of ESG scorecards, proxy advisers, investment advisers, shareholder proponents, non-investor activists and governmental organizations," she said. Ms. Peirce went on to argue that much of the material going into ESG ratings, and therefore ESG-linked indexes, come from company surveys and voluntary reports.

Todd Rosenbluth, senior director of mutual and exchange-traded fund research at CFRA Research in New York, sees such hand-wringing on ESG ratings as simply being an extension of the indexing discussion. "We have different index providers determining what are growth or value stocks based on distinct definitions," he said. "ESG is based on data and the analysis of that data. The fact that S&P and MSCI don't have the same view on the ESG ratings of companies is not that different."

Despite the potential for regulatory scrutiny, investment firms are focused on meeting expectations of future demand — within ETFs and elsewhere. Salim Ramji, senior managing director and global head of iShares and index investments for BlackRock in New York, sees four areas where investors are evaluating ESG and sustainability-focused index products: screening out certain sectors or companies, optimizing ESG scores while tracking to market-cap-weighted indexes, focusing on "best-in-class" ESG ratings, and delivering an entire asset allocation model.

BlackRock, which manages more than $7 trillion globally, has set a goal to manage $1 trillion in sustainable mandates by 2030, according to Mr. Ramji, from $90 billion at the end of 2019.

While the urgency of climate change may help drive some growth, much more likely will come from increasing transparency and mainstreaming of sustainability-related disclosures as the efforts of the Sustainability Accounting Standards Board and the Task Force on Climate-Related Financial Disclosures expand their reach.

In fact, State Street Global Advisors already filed for five ETFs tracking Bloomberg indexes based on the SASB framework and SSGA's own responsibility or "R-factor" score.

"For institutions with a robust investment office, their goals might be more precisely expressed through a separately managed account," said Noel Archard, global head of SPDR product for SSGA in Boston. Yet "as the data evolves and is consistently reported on both a company and country level, 'ESG' products will begin to feel and look more like what we now consider 'beta' products, and their utilization expanded."

Vanguard, the second-largest ETF issuer in the U.S., which has traditionally taken a much more deliberate approach to the investment product market, has not yet revealed further plans to wade into the sustainability or ESG ETF landscape.

But if there were an underserved market revealed by the recent trend, watch for interest (and offerings) in ESG-linked fixed-income ETFs and those investing in green bonds, with less than $1 billion in assets under management across just nine products, according to XTF.