In a year marked by the pandemic, exchange-traded fund investors are rushing into strategies that put environmental, social and governance concerns front and center.
ESG ETFs took in $38.8 billion globally in net inflows this year to top $101 billion in assets under management at the end of July, according to research firm ETFGI LLP. Such growth, primarily in U.S. and European-domiciled ETFs, far outstrips the pace of the overall ETF market over the same period.
Of course, this awakening of retail and institutional investors to ETFs that incorporate ESG strategies into their security selection and weightings has prompted asset managers and index providers to offer greater product choice and levels of ESG conviction. For example, BlackRock Inc. currently offers six different broad-based U.S. equity ESG ETFs and Nuveen LLC has incorporated ESG weighting into size, growth and value ETFs, among the 108 products tracked by ETFGI.
While the production of ESG data has become more robust — drawing from company, government and third-party sources — the investment community remains conflicted on the predictive power of ESG metrics for performance. Some have rushed to proclaim ESG a factor, similar to size or value, that can be isolated. But, in July, John West and Ari Polychronopoulos of Research Affiliates LLC wrote that the lack of standardized data and a limited time period for comparability muddle any ability to conclusively determine the presence of an ESG factor. They argue that even "ESG alpha" is diminished given the breadth of asset managers that are now including ESG criteria in fundamental analysis.
For ETF issuers, meeting customers where they are on ESG has turned into a mix of thematic offerings — think low carbon or diversity — and broad-based products with varying levels of ESG integration. But as Todd Rosenbluth, senior director of ETF and mutual fund research at CFRA Research in New York, recently found, "performance is highly dependent upon index construction."
"Many broad-based products are keeping sector weights consistent with their benchmark index, while significantly shifting security weights at the sector level," he said.
Mr. Rosenbluth analyzed the holdings of Microsoft, Apple, Amazon, Facebook and Alphabet across five MSCI-index U.S. ESG ETFs managed by BlackRock, including the $8.3 billion iShares ESG MSCI USA ETF. Only Microsoft and Alphabet were held by all five, with Microsoft accounting for nearly 10% of holdings in two products, while Amazon was only included in two of the five products.
Outside of a handful of clean energy ETFs, the vast majority of new assets to ESG ETFs are going to broad-based U.S. and international ETFs based on indexes from MSCI, Standard & Poor's and FTSE Russell. While performance can vary significantly based on the underlying index, expense ratios for the largest and most liquid ESG ETFs range from 0.1% to 0.7%, compared to 0.03% to 0.3% for the largest ETFs generally.
The ESG ETF market is currently seeing a product and asset boom, similar to past trends of currency-hedged and smart beta products. These trends eventually petered out as customers gravitated toward branded benchmarks, bringing assets and liquidity, and leaving secondary and tertiary products for ETF purgatory. Still, ESG ETFs are colliding with current trends as fixed-income ESG ETFs attract assets — roughly 70% of $1.6 billion in total assets arrived this year — and American Century Investments launched an actively managed sustainable equity ETF in July using one of the recently approved structures for less transparent active ETFs.
While independent research and standard-setting organizations continue to build frameworks and guidelines for company reporting, Deborah Fuhr, London-based managing partner and founder of ETFGI, sees the development of a taxonomy for sustainable investing activities by the European Union, over the next two years, as bringing clarity to both the European and non-European ETF universe. "It will help overcome some of the challenge that corporations face, trying to track and report their initiatives around these topics," Ms. Fuhr said.
For broker-dealers and registered investment advisers, Sonya Dreizler, an independent consultant to financial services firms on ESG and impact investing, said the variation in what it means to implement an ESG solution is still very broad. "The requests I see largely start from a values standpoint, either the values of the principals of the firm or the perceived potential client demand, then move to evaluating performance and risk."
"Our clients are trying to understand the financial performance drivers," said Jana Haines, New York-based head of Americas and Europe, Middle East and Africa index products at MSCI Inc. "The volume and intensity of our dialogues has been accelerated by the pandemic, but the regional differences (EU vs. U.S.) are significant."
Ms. Fuhr said, "ESG indexing will be a work in progress until a level of consistency gets developed. Eventually, we'll eliminate those items that can't be measured or don't have influence and measure better those aspects that do impact performance."
Over the next 10 years, State Street Global Advisors expects ESG ETFs and mutual funds to top $1.3 trillion in assets globally, from $170 billion at the end of May. But MSCI's Ms. Haines says that by then ESG awareness will become "such an integral part of investing" that there really won't be a difference in the market.