ESG ETF investors: always take a closer look at the ‘recipe’

The diversity of sustainability priorities means there can be no one-size-fits-all approach to ESG ETF products, says Qontigo’s Anna Georgieva and Saumya Mehrotra

Mounting attention on sustainability and climate issues has prompted a surge of interest in ESG-related exchange-traded funds (ETFs), with net new asset growth hitting 140% last year, compared with just 8% for non-ESG ETFs, according to Qontigo, provider of well-known European indices including the STOXX Europe 600, EURO STOXX 50 and Germany’s DAX. Yet with the vast array of ESG ETFs available on the market, finding the one that is best suited for a particular investor can often be a challenge.

“Sustainability means different things to different people and ESG ETFs don’t all target similar sustainable concepts or investment objectives,” says Anna Georgieva, senior sustainable investment specialist at Qontigo. “A quick glance at fund names or the indices out there can often be confusing, even for the most experienced investor.”

For Georgieva, the investment theme and the index methodology—essentially the rules or “recipe” for how to create the index—are areas where investors should take a closer look when selecting an ETF. For example, one popular theme might be climate, though not all climate-related ETFs are created the same. One approach could be to exclude certain sectors, such as fossil fuel-related companies, to reduce carbon footprint. Another approach could be to overweight companies that are performing better on certain climate indicators, and underweight those that are underperforming.

The methodologies behind these ETFs can have important implications for investors as it shapes the ETF’s exposure and thus its behaviour, including risk and return, says Saumya Mehrotra, senior sustainable investment specialist at Qontigo.

Given the range of products available, investors must start by deciding on their own sustainable investment objectives and then selecting a portfolio that is built in alignment, Mehrotra says. For example, are they looking to align their investments with their personal values, such as not profiting from industries and practices they disagree with? Or are they looking for better risk-adjusted returns through exposures to companies that are adapting their business practices to keep up with the sustainable transition? Or perhaps they want to use their capital to make the world a better place through a more specific impact investment?

For now, ETFs that adopt a broad approach using an overall ESG measure make up the bulk of the market, yet the fastest growing approaches are more impact-oriented or thematic, such as a focus on the United Nations Sustainable Development Goals or standalone social or environmental themes, says Georgieva. The market has also started to move away from pure exclusion-based approaches towards more optimised strategies that can better achieve sustainability goals without deviating too much from the broad market.

Quality ESG data is more important than quantity at this stage and meaningful product design is paramount

An additional point to bear in mind is the inherent divergence in the calculation of ESG metrics from different data providers that are used for index design. These differences in calculations can lead to entirely different outcomes, even if those ETFs have the same goals, says Georgieva. Continuing with our climate example, to measure climate risk or exposure, you need a proxy. One ESG metric underpinning a fund might use a company’s commitment to science-based climate targets (SBTs) for emissions reduction as its proxy, while another might measure the quality of the company’s reporting according to the Task Force on Climate-related Financial Disclosures (TCFD), a framework intended to unify corporate disclosures on climate-related financial risk.

“Fundamentally, both are trying to measure the same things, but come out with different exposures because of different proxies,” says Mehrotra.

Given the diversity of ETFs, it’s no surprise investors face challenges when trying to invest sustainably. There is a strong need for transparency, greater flexibility in approach and more precision in accessing specific investment objectives.

“Quality data is more important than quantity at this stage and meaningful product design is paramount,” says Georgieva.

Qontigo is heeding the call to provide sustainability-minded investors with those explainable investment solutions. By collaborating with ETF issuers, leading data providers, stakeholders from academia and the global not-for-profit sector, Qontigo aims to be a catalyst for the shift to the next generation of transparent, effective and highly-targeted ESG ETFs.

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