Exchange-traded funds that prioritise environmental, social and governance (ESG) matters have grown exponentially in popularity over the past few years.

Awareness has been boosted through global initiatives such as the Paris Agreement on climate change and the UN 2030 Agenda for Sustainable Development. Seventy-seven ETF ESG funds have been launched in the first six months of 2018 alone, although the total looks unlikely to eclipse the 214 launched over the course of 2017, according to Morningstar. Globally, there are now 2,953 funds holding ESG mandates, representing nearly $975bn in assets. The vast majority – 2,048 funds – are in Europe, with $652bn in assets.

An umbrella term

Despite significant growth, the exact definition of an ESG fund can vary greatly. Environmental issues could cover factors such as carbon emissions, whilst social matters could range from gender equality to workers’ rights. By contrast, governance issues might address directors’ pay or company transparency, for example. Some funds exclude certain companies from an index, such as tobacco and alcohol stocks, while others adopt a ‘best-in-class’ approach, selecting securities across different sectors and geographies that have a higher ESG rating than their peers.

A 2016 report from the European Commission on long-term and sustainable investment found that there was “insufficient knowledge about ESG in the investment universe” and “lack of clarity around main ESG concepts and definitions giving rise to diverging interpretations”. In France for example, the energy transition law, known as Article 173, requires institutional investors to report how they incorporate ESG factors and tackle climate change. Perhaps it is no coincidence that Lyxor and Amundi, two French ETF providers, were some of the first to enter the ESG market more than a decade ago with low carbon and water ETFs.

In May this year, the European Commission announced plans to regulate and unify the ESG market. This includes creating an EU-wide classification system, as well as improving disclosure requirements for institutional investors as to how they integrate ESG factors in their risk processes and producing a new category of benchmarks to help people identify their investments’ carbon footprint. This is, according to European Commission vice-president Valdis Dombrovskis, to prevent “greenwashing” – or the mis-selling of a product as green.

“Today we already have green labels for organic food, energy efficient appliances such as fridges, or building materials,” he said. “In the same way, we could have an EU Ecolabel for green bonds or investment funds, to give trust that an investment is actually green.”

The classification system could be implemented by 2020, Dombrovskis said, and then be expanded to social and governance objectives, which in turn affect ESG ETFs. 

“From a product manufacturer point of view, as it’s difficult to anticipate what the provisions will be, and we will have to adapt and find indexes suitable to the evolving requirements,” says Isabelle Bourcier, global head of quantitative and index at BNP Paribas.

“Our ETFs are distributed in mainly continental European countries and the MSCI SRI methodology is probably the most common ground at this stage when we discuss ESG with retail and institutional clients.”

As of June 2018, there were $11.8bn of assets tied to ETFs tracking MSCI ESG indexes globally, $7bn of which is listed in Europe.

Laurent Trottier, global head of ETF, indexing and smart beta management at Amundi, says he is “not convinced” that there would be a single definition agreed in the near future, adding that one label would be a positive thing for the ETF industry.

“Clearly, speaking the same language between providers, investors, regulators and market participants, and having the same expectations, would help improve the capacity to promote and manage ESG products,” he says.

The audience for ESG

The dominance of institutional investors in the ESG space might help to explain the lack of standardisation, notes Steffen Scheuble, CEO of index provider Solactive. 

“Different investors have different views. As a result, you have more indexes which are tailored for a specific approach and less ‘one fits all’. Due to separately managed accounts and mandates, ESG indexes are often tailored for one institutional investor.”

Deborah Yang, head of index, EMEA, at MSCI, points out that ETF assets in ESG are not broken down into retail versus institutional. “There is over $180bn in non-ETF assets tracking MSCI ESG indices and the vast majority of these assets is currently institutional,” she adds. 

“ESG investing is a relatively recent phenomenon, which has been accelerating in the last three to four years, and like other investment trends, such as factor investing, institutional investors tend to drive adoption and retail investors follow.” 

A 2017 report from US-based research firm Cerulli Associates, found that although asset managers believe demand for ESG will come from millennial investors, assets will only be accumulated slowly.

“Firms recognise that in order to draw attention from younger millennial investors, they need to begin to highlight their ESG capabilities,” the report said. “Managers believe next-generation clients are fully prepared to fire their advisers unless they put impact or values or missions into their asset allocation; therefore, they are beginning to make it a priority now.”

Trottier agrees there has been a recent shift in investor expectations and mindset. He says that-two thirds of queries from clients from the passive equity portfolio team include ESG criteria, and that this trend is starting to emerge among fixed income clients.

“I can’t say whether that shift is due to an increase in offers from index providers or whether index providers are following the trend – it’s a chicken-and-egg situation; however, we believe that it is here to last,” he said.

Breaking into fixed income

While the majority of ESG assets are in equity ETFs, the past couple of years have seen more fixed income products. For example, the Amundi Index US Corp UCITS ETF (UCRP) tracks an index of corporate-grade bonds, excluding issuers involved in alcohol, tobacco, gambling, military weapons, nuclear power, adult entertainment, civilian firearms and genetically modified organisms. Launched in late May, it already has approximately €221m under management.

Green, or social, bonds, whereby money is ring-fenced to have a positive, social impact, are another growing area of interest. Lxyor launched the Lyxor Green Bond UCITS ETF (CLIM) in February last year, and it now has approximately €53m under management. CLIM tracks a range of global green bonds deemed eligible by the Climate Bonds Initiative, an independent not-for-profit organisation that advocates low-carbon investments. 

“The topic of social bonds could be one of the next areas – that is something we are investigating,” says Solactive’s Scheuble, which has $80bn of ETF assets tied to its indices, including in low carbon, water and gender equality.

Within the broader market of fixed income, the lack of underlying securities that qualify for inclusion in an ESG index is also an issue. Andrew Walsh, executive director, head of passive and ETF specialist sales, UK and Ireland at UBS, which has $3.5bn in ESG ETFs, explains that the methodology for fixed income ESG ETFs is a “little bit looser”. 

“MSCI ESG’s scoring system has seven bands for companies, from AAA to CCC. To be included for consideration, an equity must have at least a single A,” he said. “Within liquid corporates fixed income indices, this minimum hurdle is a score of BBB. This slightly looser inclusion criteria ensures there are enough securities to choose from.” 

Lack of data

As the 2016 report from the EC found, industry participants reported that harnessing Big Data is an issue, citing how it is often needed to analyse other asset classes, or dig deeper into individual sectors and themes – including gender equality.

The €53m Lyxor Global Gender Equality UCITS ETF (GEND) launched in October 2017. It tracks an index of 150 companies around the world that score highly on 19 criteria defined by research firm Equileap, including the pay gap, maternity/paternity leave and senior female representation.

“We looked at the UN’s sustainable investment goals and women’s rights is one of the cornerstones of that,” says Adam Laird, head of ETF strategy, Northern Europe, at Lyxor. “The data from Equileap allowed us to work to construct an index in line with that goal and get the first ETF off the ground.”

The firm now has $550m tied to products that license its data. Equileap CEO Diana van Maasdijk says she aims to add extra parameters in future, such as sex-based violence at work.

“If we expand the research the existing ETF doesn’t change but it could apply to future indexes and products,” she says.

Investors are also becoming more aware that gender equality contributes to a healthy bottom line. A 2016 report from Credit Suisse found that companies with at least one female director had generated an excess return of 3.5% for investors over the previous decade. 

Fees bite

Another potential hurdle for ESG investors is relatively high fees. Data from Lipper found that the average annual fee for ESG ETFs in Europe is 41 basis points (bps), compared with 37bps for normal equity ETFs, as of June 2018. These prices have only come down by 2bps in each category since 2016. 

“There’s higher turnover in the underlying constituents in ESG ETFs than in an ETF which tracks a standard index; it’s more expensive to run these funds,” says Walsh.

“Costs will undoubtedly fall,” adds Laird at Lyxor. “We will probably see a proliferation of strategies as it’s still relatively niche.”

Does ESG mean less return?

Investors have also long debated whether ESG detracts from returns as it limits the number of stocks available to portfolio managers.

“I would say that none of the research I’ve seen was extremely conclusive,” says Trottier. “I believe that ESG is no longer just about green, ethical values, but more about managing risk and return, which is in fact a very traditional framework for any portfolio manager. The more we invest in ESG, the more we facilitate the outperformance of the best-behaving companies and the underperformance of the worst-behaving companies.”

Over the past five years, Walsh says UBS’s ETF tracking the euro-zone SRI index has outperformed the parent index by 2.11% per annum, whereas the exclusion of big tech stocks has hampered SRI ETF performance in the US, as has the underweighting of China in emerging market SRI ETFs.

“It’s not like all SRI indices have the same performance against their respective parent indices,” says Walsh. “While the Eurozone (EMU) SRI has outperformed the parent, non-SRI index, massively in recent years, it doesn’t mean all SRI indices outperform the parents. In fact, with emerging markets SRI, it has underperformed. The simple point being that there is not one absolute situation where SRI outperforms all the time.”

Lyxor’s Laird adds that ESG funds generally performed well between 2005 and 2007. But after the financial crisis, they tended to underperform as they screened out natural resources and mining companies.

“Is that a failing of these funds? I don’t think so,” he says. “It’s just a recognition you’re getting performance from different areas at different times.” 

According to the EC’s 2016 report, sustainable finance may not become the norm for years, or even decades. But Solactive’s Scheuble notes that though there is still “more talk than assets” when it comes to ESG, investor trends are moving in the right direction.

“From my perspective we are right at the beginning,” he says. “But I’m convinced that every ETF provider will offer ESG products in the future.”