2018 marks the year that exchange-traded funds (ETFs) dedicated to tracking environmental, social and governance (ESG) issues truly became mainstream.

As the overall global ETF industry grew to $5.7trn (€4.9trn) at the end of August, according to ETFGI, the independent research and consultancy firm, investor focus has increasingly been on those funds that tap into the investment world’s current zeitgeist.  

Nearly 80 ETF ESG funds have been launched so far this year, as Rachael Revesz reveals in her deep dive into the sector for this year’s report. As she uncovers, ESG funds in this area now account for almost a fifth of all assets across the ETF industry. 

Interest is growing, and fast. Several reasons are at work here, not least the fact that a younger generation of investors is keen to put its money to work for social good as well as high returns. Debates about ESG may continue, but the larger investment houses are moving in response to increased – and sustained – demand.

So far this year, inflows into ESG – and the ETF sector as a whole – are not as strong as they were in the corresponding months of 2017, perhaps indicating investor nervousness over more macroeconomic indicators such as Brexit, the worsening trade dispute between China and the US and increasing uncertainty over the short-term future of President Donald Trump. 

Volatility alert

“It seems likely that investors will experience more volatile global markets in the near future,” says Danny Dolan, managing director at China Post Global, the Hong Kong-headquartered investment company.

Perhaps unsurprisingly as they serve as a leveraged play on the more developed indices, the emerging markets took the brunt of investor disaffection. 

“Emerging market equity ETFs saw steady inflows since the beginning of the year until the end of April, with investors mainly using global emerging market indices followed by Asian emerging market indices, but from May through to July, emerging market equities recorded outflows, peaking in June,” says Keshava Shastry, head of ETP capital markets at DWS. 

“In terms of performance, emerging market equities started the year with a small positive return in Q1 followed by a sharp fall in Q2. This was mainly driven by a lot of headwind coming from US dollar strength and escalated global trade tensions.”

Yet despite the return of investor nerves, the overwhelming amount of assets remain committed to equity investing, ETFGI figures reveal. At the end of August, of the overall $5.7trn, $4.1trn was in equities compared with $838bn in fixed income and a relatively modest $125bn in commodities. The ETF industry now represents approximately 15% of the assets invested across all mutual funds, according to Morningstar data.

China Post Global’s Dolan suggests investors seeking to hedge turbulent markets should plump for smart beta, which combines both active and passive management strategies.

“For passive investors, taking a selective approach to stock screening, such as smart beta, rather than embracing the market as a whole, can help mitigate the effects of this volatility,” he says. “In this environment, the right smart beta approach can create value for investors.”

Looking to objectives

Smart beta has become common currency in recent years, particularly for larger institutional investors. But even this is evolving, adds Caroline Baron, head of ETF sales EMEA at Franklin Templeton.

“The world of investing is no longer about active or passive, nor is it about smart beta versus market-cap,” she says. “It is about portfolio construction and ultimate objectives.

“Within smart beta, we’ve seen some evolution with the emergence of multi-factor solutions designed to serve a specific objective (either risk reduction, return enhancement or diversification) and also addressing the challenge of ‘factor selection’.”

In essence this is leading to a greater understanding of how ETFs can work as part of an active portfolio, rather than using them in their more traditional sense as passive vehicles that track markets, indices or other more esoteric areas.

“An active ETF exhibits the features of a traditional ETF like transparency, low cost and flexibility,” explains Baron. “Instead of following an index though, these ETFs are aiming to beat the benchmark. They are ‘benchmark aware’, which means that they use the underlying from a certain universe but the ultimate objective is to beat the performance of that universe.”

This view is widely held across the industry, which is devising increasingly sophisticated products around what used to be seen as a practical, vanilla core holding. 

‘‘ETFs represent the next leg of the global indexing revolution,” says Jim Norris, managing director of Vanguard’s international operations. “They are truly disruptive vehicles, simply because they are so democratic. Investors can access them at any time, on a whole range of exchanges and, as a result, we’re already hearing investors, across a number of different markets, asking for portfolios to be built using ETFs. If you haven’t heard that conversation already, you will soon.”

After BlackRock, Vanguard is the second-largest ETF player in terms of assets under management. Norris sees the low-cost flexibility of ETFs as offering a solution for the asset management industry in these times of increasing pressures on margins.

“Throughout the international markets that Vanguard operates in, we’re seeing wealth managers and discretionary portfolio managers increasingly use ETFs as flexible, low-cost building blocks that help them to deliver high-quality products whilst maintaining their margins,” he says. 

“We expect margins to come under increasing pressure in the years to come, so ETFs are likely to continue to play an important role in this respect.”

Technology shapes future

Looking forward to next year’s guide and beyond, innovation seems to be the watchword. ETFs – whether ESG or those tracking whisky futures – are firmly ensconced in the mainstream. What will ultimately determine the future is technology, Vanguard’s Norris believes.

“Technology will provide the transparency that investors deserve,” he says. “It’s easy for a fintech start-up to build a technology-driven asset allocation model and to implement that model using low-cost ETFs. They can then distribute it online with low overheads. These suppliers can help bridge the advice gap for lower-income investors, but they’re not just for beginners: wealth investors are using them too.”