© Efi Chalikopoulou

Index-tracking funds that employ environmental, social and governance metrics are attracting record-breaking inflows, as rising numbers of investors adopt strategies that go beyond achieving the best financial return.

And this demand for ETFs that aim to align investment imperatives with “do good” objectives reflects a growing level of shareholder activism — focused on objectives such as combating climate, tackling racism, encouraging gender diversity, and challenging excessive executive pay.

Investors ploughed $97.4bn into ESG ETFs in the first seven months of 2021, as new business accelerated sharply from the record $89bn gathered over the whole of last year.

This boosted global assets in ESG-focused ETFs to $309bn by the end of July, according to ETFGI, a London based consultancy. 

But such rapid growth has also created controversy over whether the growing number of products with ESG-themed mandates are achieving their advertised objectives.

On recent evidence, many of the vehicles are demonstrating that “doing the right thing” does not mean financial return objectives need be overlooked.

Carolyn Weinberg, global head of product for the iShares ETF and index investments business at BlackRock, says that the resilient performance of many ESG-themed ETFs during the market turmoil that accompanied the onset of coronavirus has increased investors’ appetite for such products.

A study published in January by the data provider Morningstar found that 25 out of 26 ESG equity index trackers beat funds that were conventionally weighted by market capitalisation, when it came to tracking the most common benchmarks last year.

“Some of the outperformance in 2020 was due to sector and factor exposures but it was also driven by single stock selection — which showed that ESG scores do matter,” says Weinberg. “It made investors realise that the outperformance delivered by ESG is real. It has led to an increase in adoption everywhere.”

Bar chart of Assets in ESG ETFs ($bn) showing BlackRock holds commanding lead in ESG ETF race

Confidence is spreading among investors that companies scoring well on ESG criteria can also deliver better risk-adjusted returns.

Coalition Greenwich, a US consultancy, interviewed 151 portfolio managers at pension funds, endowments and foundations in North America and Europe this year, and found that more than a quarter (27 per cent) of the respondents thought sustainable investments would outperform the relevant benchmarks. A fifth of the respondents said that positive benefits could be delivered by incorporating ESG into their portfolios, while 11 per cent said ESG would help to reduce risks.

“Institutions expect sustainable investments to generate attractive returns, either matching or outperforming benchmarks,” notes Davis Walmsley, a managing director at Coalition Greenwich. “[But] many also expect additional benefits, such as portfolio diversification or enhanced risk management.”

Bar chart of $bn showing Net inflows into ESG ETFs

However, these rosy expectations are challenged by Bradford Cornell, an emeritus professor of finance at UCLA’s Anderson School of Management. He believes that any outperformance delivered by companies highly rated on ESG criteria will prove temporary. “Investors who favour using ESG criteria when choosing investments cannot expect to have their cake and eat it, too,” Cornell argues. “Tilting portfolios toward higher rated ESG securities is almost certain to reduce risk-adjusted returns over the long run.”

Despite this scepticism, regulators — particularly those in Europe — are pressing pension funds and other institutional investors to integrate climate considerations into their decisions over asset allocation, which is fuelling demand for sustainable investment strategies, including the use of ESG ETFs.

Nearly eight out of 10 of the institutional investors questioned by Coalition Greenwich expected to use sustainability criteria in their investment decisions by 2026.

Similarly, a survey by BlackRock found that a group of 425 institutional investors, which together oversee $25tn, plan to double their allocations to sustainable strategies from 18 per cent of total assets to 37 per cent by 2025.

Managers are rushing out new products to meet this interest.

“We have seen massive product proliferation since the first ESG ETF was launched in 2001,” says Deborah Fuhr, managing partner and founder of ETFGI. “The number of ESG ETFs launched has almost doubled to 644 [now] from 324 as recently as the end of 2019.”

But ESG-focused ETFs come in a variety of shades of “green” — ranging from “light” to “dark”.

“Lighter green” versions are generally designed to deviate only slightly from the returns delivered by a parent index weighted by market capitalisation, while they pursue investments that can promote ESG aims, such as reducing in carbon emissions.

By contrast, “Dark green” funds, such as so-called “Paris-aligned” ETFs, will aim to achieve a much larger reduction in carbon emissions by investing only in the top-rated or best-in-class ESG companies.

“There is a wide divergence in the approaches offered by ESG ETFs which is not always fully appreciated by investors,” says Walmsley.

Paris-aligned ETFs have been designed to align with the goal of curbing the increase in global temperatures to 1.5C compared with pre-industrial levels. Their holdings must have a carbon intensity — grammes of carbon dioxide per dollar of revenue — half the level of the parent index and they must also meet future decarbonisation targets. However, ETFs with mandates to make investments that align with the ambitions of the Paris climate accord generally have fewer constituents — meaning a potentially wider range of return outcomes than their parent index.

BlackRock’s MSCI World Paris-aligned ETF, known by its ticker as WPAB, has 684 constituents, compared with the 1,291 companies included in its conventional MSCI World ETF, known as URTH.

Even so, Sasja Beslik, head of sustainable finance development at J Safra Sarasin, the Swiss private bank, says that the criteria used to choose constituents for some Paris-aligned ETFs are not sufficiently rigorous to ensure that global temperature increases would be limited to 1.5C.

“Our analysis suggests that just 176 companies from 6,000 listed globally have a business plan consistent with a 1.5C pathway,” he says.

Rapid product proliferation has also fuelled concerns among regulators about the problem of “greenwashing”, whereby managers make unjustified claims about the environmental qualities of their funds.

Germany’s financial regulator BaFin launched a consultation in August with the aim of tightening the requirements that asset managers will need to meet when setting up funds labelled as “sustainable”.

German Federal Finance-service Control Agency (BaFin) in Bonn, Germany © Hermann J Knippertz/AP

Two whistleblowers that previously held senior ESG roles at asset management companies have also made stinging criticisms about so-called ‘sustainable’ ETFs.

Desiree Fixler, the former ex-head of sustainability at DWS, the German asset manager, says that most ETFs are “not impact orientated” and “do little to stop climate change or social injustice”.

“Asset managers need to show that the companies owned by ESG ETFs are actually changing the world for the better,” says Fixler. 

Tariq Fancy, who was global chief investment officer for sustainable investing at BlackRock for almost two years until 2019, likens ESG funds to “selling wheatgrass to a cancer patient.” He has described the “lofty and misleading marketing messages” about ESG by asset managers as a “deadly distraction” from dealing with the risks of climate change.

In response, BlackRock says that ESG ETF inflows can only help to drive the decarbonisation of the global economy.

“Every company is waking up to ESG,” says Weinberg. “Investor inflows into ESG funds are driving big changes and forcing more companies to think about their policies. These changes in corporate behaviour will increase over time.”

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