ETFs

Investing in Environmental, Social and Governance (ESG) Themes using Exchange Traded Funds (ETFs)

This article was co-authored with Vivek Bagai, who assisted in data aggregation and analysis.

Investing in companies that are environmentally and socially responsible is one of the fastest growing trends in the US. Not surprisingly, many investors are accessing ESG strategies using Exchange Traded Funds (ETFs). As of October 29, 2019 there were 91 ESG oriented ETFs in the US with over $16B in net assets, as listed in the CFRA First Bridge ETF database.

The list of ESG ETFs is varied, with a range of strategies available to investors. This universe can be broadly classified into the following categories:

  1. Diversified ESG: Access to firms that score high on parameters that span environmental, social and governance issues without specifically focusing on one of those areas. This is the largest category, accounting for 68% of ESG ETF assets in the US.
  2. Renewable Energy: Access to firms engaged in solar, wind or other renewable energy related businesses (10% of assets in ESG ETFs).
  3. Governance & Employment Practices: Access to firms that score high on corporate governance metrics or specific employment practices such as having women in leadership positions or hiring military veterans (also 10% of assets).
  4. Low Carbon Footprint: Access to firms across industries that have low carbon emissions relative to peers or other firms.(7%).
  5. Faith based: Access to firms that meet certain screening criteria based on faith based principles e.g. Biblical values or Islamic Shariah guidelines (4%).

We classify the remaining ESG ETFs (1% by assets) into a catch-all ‘other’ category. This breakdown is summarized in the pie chart below:

ESG ETFs by type

ETF data: CFRA First Bridge ETF Database; October 24, 2019

Even within an ESG category, the methodology used to select and weight securities can vary widely between ETFs. Understanding these differences is critical since it can result in the ETFs having very different risk / return characteristics.

Inclusion vs. Exclusion Approach: Comparing Three ‘Low Carbon Footprint’ ETFs

One approach to constructing ESG ETFs is to take a ‘positive inclusion’ approach i.e. create a set of ESG criteria and then select or overweight those securities that perform well on that parameter. This is the approach adopted by the iShares MSCI ACWI Low Carbon Target ETF (‘CRBN’). In constructing this ETF, all the securities in the parent universe are rated based on carbon exposure scores. Securities with low carbon exposure are over-weighted relative to their traditional market cap, and those with high exposure are under-weighted. This approach, in combination with sector caps, ensures that the ETF does not vary outside of a defined range from its parent benchmark. An inclusion approach with sector caps works well for investors who want to factor ESG criteria into their investment decisions, but don’t want to stray too far from the original parent benchmark.

By contrast, the SPDR MSCI EAFE Fossil Fuel Reserves Free ETF (‘EFAX’) excludes, rather than underweights, securities that have fossil fuel reserves. Firms in the parent universe that have these reserves are not considered for inclusion in the index underlying the ETF. This exclusionary approach is better suited for investors who have a firmer conviction about ESG investing i.e. they either definitively don’t want to invest in a specific type of company or believe that excluding those firms could result in outperformance.

The Etho Climate Leadership US ETF (‘ETHO’) uses a combination of both inclusive screening and exclusion. Securities that rate highest on carbon efficiency (i.e. low carbon emissions per dollar invested) are considered for the ETF, an inclusionary approach. However an additional exclusionary screen is applied to eliminate firms in certain businesses such as weapons manufacturing and gambling.

These three products are summarized in the table below, and it highlights how ETFs even within the same ESG category can have different methodologies, and therefore varying exposure characteristics.

Table: A Comparison of 3 ‘Low Carbon Footprint’ ETFs

A Comparison of 3 ‘Low Carbon Footprint’ ETFs

Key ETFs in the US by ESG Category

The table below lists the largest ETFs in the US by net assets within each ESG category. It includes a range of ETFs that span both the inclusion and exclusion based construction methodologies.

Table: Largest ETFs in the US by ESG category

Largest ETFs in the US by ESG category

ETF data: CFRA First Bridge ETF Database; October 24, 2019

Acceleration in ETF Launches

As we have seen, there are now over 90 ESG themed ETFs in the US. Of these, a significant number have been launched in the last 3 years. The chart below shows the current ESG ETF universe by inception year. It is clear that there has been a significant spike in launches after 2015.

Current ESG ETFs - By Inception Year

The overall ETF universe providing access to ESG strategies has grown dramatically in the last few years. Flow data as well as investor interest appears to indicate this is a long term trend, and that factoring in ESG criteria into the investment process could become a matter of course for both individual and institutional investors.

Aniket Ullal is global head of ETF data and analytics for CFRA Research. Previously he was the founder of First Bridge Data, a provider of ETF data and analytics that was acquired by CFRA. Prior to founding First Bridge, he had product management responsibility for S&P’s US indices, including the widely followed S&P 500 and S&P/Case-Shiller indices. These indices have over $250B in ETF assets tracking them. He is the author of 'ETF Investment Strategies' (McGraw-Hill; 2013).

In This Story

CRBN EFAX ETHO

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ESG Sustainability

Aniket Ullal

Aniket Ullal is the founder and CEO of First Bridge Data (www.firstbridgedata.com), a provider of independent ETF data and analytics to institutional clients. Previously he had product management responsibility for S&P’s US indices, including the widely followed S&P 500 and S&P/Case-Shiller indices. These indices have over $250B in ETF assets tracking them. He is the author of 'ETF Investment Strategies' (McGraw-Hill; 2013).

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