Over the past decade, it has been nearly impossible for financial professionals to ignore Environmental, Social and Governance criteria (ESG) when making investment decisions. Their impact on asset inflows has been phenomenal and shows that sustainability is no longer merely a trendy idea but a prerequisite for a well-constructed portfolio.
Although great attention has been given to this paradigm shift, the lack of universal standards which are truly global both in theory and in practice and the vast amount of ESG data available make it difficult for investors to know how to deal with this challenge.
The following sections review this challenge in more detail and call for innovation and stronger collaboration between all stakeholders.
A look at the current landscape of ESG ETFs
The ESG ETF market has evolved very quickly over the past years. A few pioneers, ETF issuers and index providers, have emerged as key players in the current landscape.
The fast rise of ESG ETFs
According to TrackInsight, the number of ESG ETFs worldwide has jumped from fewer than 50 in 2014 to over 300 in 2019 (Figure 7.1). Their assets under management (AUM) have also risen exponentially, growing from $6 billion in 2014 to $51 billion in 2019.
Figure 7.1: Growth of ESG ETFs worldwide over 2014-2019 in $bn and numbers
Source: TrackInsight, IHS Markit, year-end data
If we appraise such growth in the context of the overall market, the results are even more outstanding. Compared with 2014, the number of ESG ETFs has multiplied by 6.58 and their AUM skyrocketed by more than 764% (Figure 7.2), thereby dramatically outpacing the growth rate of all ETFs (ESG and non-ESG combined).
Figure 7.2: Growth of AUM and number of ESG ETFs and ETFs worldwide over 2014-2019
Source: TrackInsight, IHS Markit, year-end data
The major players in the ESG ETF market
Surfing on the wave of ESG investing around the globe, the leading ETF issuers and index providers have played an important role in ETF market developments towards a more sustainable society. As of March 31, 2020, more than 45% of ESG ETFs had been issued by iShares and UBS (Figure 7.3). Regarding benchmark index providers, MSCI, with its ESG research team, provides indices tracked by 54% of the ESG ETFs (Figure 7.4).
Figure 7.3: ESG ETF issuers market share (in terms of number of ETFs available)
Source: TrackInsight, as of 2020-03-31
Figure 7.4: ESG index providers market share (in terms of number of ETFs tracking indexes)
Source: TrackInsight, as of 2020-03-31
Exploring the different ESG approaches
Investors now have access to an extensive and expanding pool of ESG products. Institutions such as UNCTAD provide a framework to help them distinguish between different approaches to sustainability.
UNCTAD’s ESG strategies breakdown
According to the UNCTAD ESG ETF Report (2019), strategies for developing ESG-related products can be grouped into the following four categories.
Figure 7.5: The four ESG strategies according to UNCTAD
Despite increasing take-up, there is a glaring disparity in the distribution of ESG ETFs by domiciliation.
In terms of both the sell-side’s offering (the number of ESG ETFs) and buy-side’s appetite (the AUM of ESG ETFs), Europe appears to dominate the global ESG ETF market, totalling 229 ETFs with sustainable exposure. This number is larger than that for the U.S. and APAC combined as shown in Figure 7.6.
The approaches favoured by investors also vary considerably across the globe. In the U.S., 67% of investors embraced the broad ESG tactic, while European investors converged on positive screening approaches (65% of AUM) to maximize the potential benefits of sustainable investment.
Figure 7.6: Regional breakdown of ESG strategies – AUM and number of ETFs
Source: TrackInsight, IHS Markit, as of 2020-03-31
Investors have stuck with ESG ETFs even during the COVID-19 turmoil
The dark cloud of the coronavirus pandemic has brought heightened uncertainty to markets globally. While the broader market has suffered the worst quarter ever in terms of both returns and flows, investors continued to purchase ESG ETF shares.
The net inflows of global ESG ETFs in Q1 2020 show that investors are maintaining their confidence in this strategic direction even under adverse market circumstances. Among the four abovementioned strategies, investors have favoured Best-in-Class and Full Integration.
Figure 7.7: Net inflows into ESG ETFs over Q1 2020 vs Q1 2019
Source: TrackInsight, IHS Markit
Along with these remarkable inflows, the performance of ESG ETFs seems to indicate that this kind of strategy has passed its first “real-world” test.
Figure 7.8 compares the performance posted by the MSCI ACWI index, which covers about 85% of the global set of investable equity opportunities, with four of its ESG variants during the COVID-19 outbreak.
Figure 7.8: Relative performance of MSCI ESG Indexes vs MSCI ACWI Index over Q1 2020
Source: MSCI data from Dec. 31, 2019 to March 31, 2020.
ESG strategies have demonstrated some resilience during the recent market turmoil. This could well stem from the sustainable approach to security selection, as sustainable indices are generally comprised of companies with higher profitability and lower levels of leverage than the broader market. Companies with healthy balance sheets and sound governance practices may be better positioned to focus on mitigating ESG risks and introducing sustainable practices than their less-profitable peers.
Moreover, investors need to be fully aware that such outperformance can also be attributed to different sector exposures. More time should be taken into consideration before attempting to conclude boldly on the benefits of ESG investing.
Indeed, ESG ETFs generally hold a higher weight in the technology industry while underweighting the energy industry, which was hit hard by the historic plunge in oil prices. This further proves that the true financial impact of ESG investing can only be assessed with certainty over much longer periods.
The many challenges of ESG analysis
Despite the rapid growth of ESG ETFs worldwide, embedding sustainable investment practices into investment processes remains a complicated task which is not easy to describe and could therefore be confusing to investors, even if they have shown great interest in this disruptive approach.
The idea of contributing to a more sustainable world while creating added value is shared by most investors, but there are still many practical challenges that have not yet been resolved. The apparent complexity of this conceptual framework goes beyond conventional financial inferences.
The ESG factors are broad enough to support different interpretations. In the absence of reliable and comparable measurement standards, many investment management firms strive to define E, S, and G within the scope of ESG investing.
Nevertheless, the great variety of ESG approaches may also affect the market, as investors are easily disoriented. Inconsistency and unavailability of data have already troubled many stakeholders who tend to incorporate ESG factors into index-based strategies.
The development of guidelines and taxonomy to improve market standardization remain long-term endeavours.
ESG investing calls for innovation and collaboration across entities
In order to ensure a smooth transition towards this strategic trend and mitigate any side effects from its implementation, innovation and collaboration between financial institutions are required. Regulators, NGOs, governments, and intergovernmental agencies should also assume their share of responsibility.
ESG consensus methodology
Amid all this, consensus should help to reduce complexity. From this perspective, Conser, a Swiss-based, independent consulting company 100% dedicated to sustainable investing, suggests an innovative way to objectively assess investment funds by combining investors and experts’ views.
This consensual approach provides a holistic picture of the sustainability risks associated with an investment. It conducts a meta-analysis of quantitative and qualitative ESG data based on collective intelligence, reflecting the average view of the market, from major rating agencies to the best sustainable asset managers. This approach gathers the opinions of these various experts without judging which is right or wrong. The degree of dispersion of these views is considered to define the final sustainability score, which is provided on a granular scale with 10 levels: A+, A, A-, B+, B, B-, C+, C, C-, and D.
Totting up ESG scores for each strategy reveals that most sustainable ETFs implement positive-screening strategies, closely followed by fully-integrated strategies. On the other hand, the pure negative-screening strategy (Exclusion) does not seem to prove the funds’ overall sustainability.
Figure 7.9: ETFs count by ESG strategies and ESG score
Source: TrackInsight, Conser. ESG scored based on holdings of ESG ETFs as of 2019-12-31. Synthetic funds excluded.
Overall more collaboration is still needed between stakeholders
The goal of sustainable development can only be achieved through international cooperation, so it is more important than ever for all stakeholders and not just financial entities to keep an open mind.
Figure 7.10: Current initiatives of industry collocation
Source: UNCTAD, Leveraging the Potential of ESG ETFs for Sustainable Development, 2019
Policymakers and regulators need to participate in the process of improving the coherence and consistency of sustainability reporting and ratings, while also ensuring that these standards remain market driven.
 UNCTAD – Leveraging the Potential of ESG ETFs for Sustainable Development – 2019