In Focus: Passive Investing  

How to choose an ESG exchange-traded fund

  • To understand how ESG operates within an ETF.
  • To be able to explain the pros and cons to clients seeking ESG ETFs.
  • To learn how to assess the stewardship potential of passive ESG funds

Dutt says that “ESG ETFs enable investors to include their social convictions in their portfolio selection process” because “index-linked strategies follow transparent rules-based approaches.

"As such, passive funds lend themselves well to positive and negative screens that underline many sustainability-oriented strategies.” 

Portfolio construction

This advantage of a transparent, rules-based approach is also picked up on by Treiber, who explains: “ETFs are benefitting from a good adoption rate in Europe given the many benefits they offer investors, such as allowing them to build diversified portfolios in a low cost, transparent and efficient way across asset classes.”

The efficiency is noted by Mellor who also links this to clarity and simplicity of the approach.

He says: “One key reason for the growth in ETFs is the simplicity and clarity that is offered by a passive or index-tracking approach. This applies as much, if not more so, to the growth in ESG ETFs.

"The fact that index rules explicitly lay out the ESG exclusion and selection rules makes it easy for investors to assess which ESG approach best meets their specific requirements, supported by the knowledge that the ETF will then track that index, matching those ESG rules.”

According to Treiber, this makes passives and ETFs “the instrument of choice for many advisers and investors” in several ways, not to mention the fact that an ETF can provide diversification for investors without the price tag attached to active fund management.

Trieber says: “One feature that has supported this trend has been the ease of gaining exposure to a diversified basket of stocks or bonds in one trade.

"For many investors trying to build portfolios from a top-down asset allocation perspective, ETFs provide a useful tool they can use, which is generally priced more competitively than many actively managed strategies.”

However, the issue of diversification is a controversial one when it comes to ESG ETFs.

While Treiber notes that ETFs also allow investors to capture exposure to asset classes they would not otherwise be able to easily capture, with lower initial capital commitment required to build a diversified basket of holdings, Morningstar’s Dutt feels differently.

Dutt explains: “With ESG ETFs, there’s a potential trade-off between high ESG exposure and low tracking error. Funds with higher sustainability scores tend to be more concentrated compared to funds with lower sustainability scores.

"Retail investors with the highest social convictions may prefer purer ESG exposures but at the expense of diversification. Meanwhile, clients with lower social convictions may prefer funds that track broad market cap indices more closely."

This point on diversification may weigh against investor’s intentions to invest ethically.