Opinion

Stuart Kirk is right about ETFs but wrong about impact of flows

ETF flows can impact the performance of the underlying market

Tom Eckett

a person giving a presentation

Flows in or out of exchange-traded funds (ETFs) can have a significant effect on the performance of underlying securities despite recent claims made by HSBC Asset Management’s former global head of sustainability Stuart Kirk.

AtETF Stream’sESG ETFs Investor Workshoplast week, Kirk delivered a fantastic keynote on why ETFs have a more important role to play in sustainable investing and the transition to net-zero than their active counterparts.

In particular, he argued divestment – the process of removing securities from a portfolio – will have no impact on financial performance as these assets will simply be hoovered up by another investor which may not be as concerned about a company’s ESG strategy.

“No amount of inflows and outflows from ETFs affect the price of underlying securities,” Kirk stressed. “It is fundamental cash flow and the outlook of companies decided by active managers that determines price.

“By definition, for every seller, there is a buyer and for every buyer, there is a seller. It does not matter for the company one bit.”

From an ESG perspective, this makes perfect sense and there are numerousacademic studiespointing to the power of engagement over divestment, or simply put, having a seat at the table.

As a result, by holding more securities, Kirk, who resigned from HSBC Asset Management in July, explained ESG ETFs can engage with more management teams and deliver more success than active managers that hold concentrated positions in potentially niche areas of the market.

However, from a performance perspective, forced divestment – on a significant scale – does have the potential to impact a security’s price, despite what Kirk argues.

The ETF market has a perfect case study in the less liquid thematics space. In 2020, the iShares Global Clean Energy UCITS ETF (INRG) and its US counterpart, the iShares Global Clean Energy ETF (ICLN), saw a significant spike in demand which totalled $7.5bn inflows over the 12 months.

The huge inflows started to drive the performance of the underlying companies – many of which were small caps – causing INRG to deliver 136% returns that year.

Recognising the structural issues with tracking 30 pure-play clean energy stocks and incorporating a maximum weighting of 4.5%, S&P Dow Jones Indices changed the strategy to include more stocks and reduce their ownership of small companies in order to protect products tracking the index from a potential reversal in demand – and subsequent liquidity doom loop.

As Société Générale explained at the time: “These large holdings might have contributed to some buying pressures on the related stocks and, conversely, could lead to selling pressures if the ETFs were to offload all or a large portion of their holdings owing to index composition changes and/or ETF outflows.”

What this shows is ETF flows can impact the financial performance of companies. As a result, ESG investors should look to allocate capital to businesses – or ETFs – delivering the biggest impact in the transition to net-zero.

While it is crucial not to forget the biggest sinners in this transition, a popular ETF that blindly allocates to a basket of low ESG-scoring stocks could help in the financial performance of those companies, even if it is in the short term.

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