ESG-focused ETFs target quant methods, transparency

As investment strategies focused on sustainability and environmental, social and governance factors draw scrutiny, exchange-traded funds are leaning on quantitative methodologies and portfolio transparency to continue to attract assets. That's all the more crucial with regulators sharpening their focus on fund processes and marketing.

According to data from London-based research firm ETFGI LLP, global ESG ETFs gathered $97.4 billion in net flows through the end of July, $8 billion more than the entirety of 2020, while closing that month with $309 billion in total assets. And as more pension funds and endowments move to drive their portfolios to net-zero or align with diversity goals, expect ESG ETFs assets and products to grow with those institutional investors.

Take Harvard Management Co. In a recent letter to members of the Harvard community, Harvard University President Lawrence Bacow reiterated the endowment's goal of a net-zero portfolio by 2050, yet HMC still reports $45 million in broad-based equity ETF holdings that could be replaced by similar offerings with lower carbon intensity.

Many other institutional investors and large financial intermediaries have found room in their portfolios for both domestic and international index ETFs that also incorporate ESG factors. For example, Blackrock Inc.'s $22.4 billion iShares ESG Aware MSCI USA ETF has added $5.9 billion in net flows through Sept. 10, according to FactSet Research Systems Inc., while Vanguard Group Inc.'s $5.3 billion Vanguard ESG U.S. Stock ETF has added $1.5 billion. Though both funds cover the U.S. market, their market-cap coverage and exclusion levels diverge.

"Oftentimes, two funds with 'ESG' in their names may have completely different sector exposures, integration methodologies, exclusions and levels of concentration," said Kiley Miller, associate portfolio manager, PMC Impact Portfolios at Envestnet Inc. in New York. ESG and related thematic ETFs now total more than $5 billion on the company's platform, a nearly 200% year-over-year increase through the end of June, according to Ms. Miller.

Among other services, Envestnet offers a wealth management platform for financial advisors and institutions that includes portfolio solutions.

"We are where the factor ETF market was nearly a decade ago," said Aleksey Mironenko, managing director and global head of investment solutions for Leo Wealth, a global wealth adviser in Hong Kong. "Whether the underlying ESG data is based on MSCI or Sustainalytics, ETF providers are trying to build products with more intelligent tilts," he said.

Despite the rush of new and announced ESG-focused ETFs available, Mr. Mironenko said that very few are appropriate for large-scale investment once expense ratios, liquidity and trading spreads are considered.

To counter the reduced exposure to the energy sector of many broad-based ESG ETFs, Mr. Mironenko looks to clean-tech ETFs. "We have to own the companies that the market will look for tomorrow," he said.

That's part of the thesis behind BlackRock's April launch of two actively managed ETFs focused on companies' readiness for the transition to a low-carbon economy. Significant early investors in the products — one focused on U.S. companies and one on non-U.S. companies — include the $310.9 billion California State Teachers' Retirement System, Varma Mutual Pension Insurance Co., Factory Mutual Insurance Co. and Temasek Holdings Ltd.

With a combined $2 billion in assets under management, the actively managed carbon transition readiness funds bring a low-cost, systematic approach to an ESG product while allowing for flexibility as data matures, according to Carolyn Weinberg, managing director of BlackRock's global head of product of the iShares and index investment business in New York. "Active management lets us evolve the signal strength and the screen," she said.

Ms. Weinberg added that "COVID really changed the conversation for ESG investing," as broad-based ESG-indexed products, in particular, outperformed during the March 2020 drawdown. While sector and factor tilts may drive some outperformance (more tech, higher quality), BlackRock found that ESG scores were the largest contributor in an attribution analysis.

"The market is rewarding companies with higher ESG scores," said Scott Ladner, chief investment officer at Horizon Investments in Charlotte, N.C. "It's an emerging factor."

Despite transparent processes and portfolios, ESG ETFs still face scrutiny and will continue to be challenged on the wide-range of definitions and goals that plague sustainable investing. Take London-based InfluenceMap, a nonprofit that evaluates corporate climate policy and lobbying, which found global ESG funds and ETFs falling short of alignment with climate criteria in the Paris Agreement or reduced fossil fuel intensity, without concern for whether the funds' stated goals included such metrics.

But the U.S. fund industry is sharpening its focus now that EU funds are under the Sustainable Finance Disclosure Regulation. After initially calling for just voluntary corporate reporting of certain ESG information, the Investment Company Institute said in a June comment letter to the U.S. Securities and Exchange Commission that it supports required Scope 1 and 2 GHG emissions reporting established by the Greenhouse Gas Protocol; utilization of the Task Force for Climate-related Financial Disclosure framework; as well as the disclosure of EEO-1 data — the mandatory annual filing of workforce demographics to the Equal Employment Opportunity Commission for all private sector employers with more than 100 employees. Such quantitative and qualitative statistics would provide additional support for ESG fund and ETF offerings.