The environmental, social and governance (ESG) boom is well and truly underway with ETFs set to play a major role in the shift to sustainable investments, however, challenges remain for an industry still in early stages of rapid growth.
Last year proved to be a watershed year for ESG ETFs. According to data from BlackRock, EMEA ETF industry cumulative flows in 2020 were $127bn with ESG ETFs closing at $52bn. ESG ETFs made up 41% of the total compared to only 14% in 2019.
Somewhat interestingly, ESG ETFs have proven much stickier assets than their non-ESG ETF counterparts.
Highlighting this, the segment saw €730m inflows during the extreme volatility in March, according to Morningstar, while European ETFs overall suffered their worst monthly outflows on record with €22bn pulled from the market.
The significant surge in demand this side of the pond was driven by an increasingly conscious investor set, regulatory tailwinds, performance opportunities and the recognition ETFs provide the perfect tool for investors to express their sustainable views.
Highlighting this, a survey of 400 professional European investors conducted by Censuswide studied the reasons why respondents used ESG ETFs. Some 27% of respondents said they liked the benefits of traditional ETFs – the most cited answer – while 26% said they like the transparency and simplicity ETFs offer and 24% said they like the ability to select specific ESG outcomes.
As Andrew Limberis, investment manager at Omba Advisory & Investment, told ETF Stream: “Where the relationship between ESG and indexing works well is in the transparency provided by ETFs. It is clear to investors exactly what they own and having a rules-based methodology provides clear reasons for holding a security and in determining its weight.
“Having this clarity is important to ESG investors who want to know what companies they are invested in and may have an opinion on that company. As obvious as it sounds, ETFs are also dynamic in the sense that as the underlying data changes, the composition of the ETF will change.”
Despite the rapid development of the ESG ETF space, one area that continues to be a challenge is around ESG data. As highlighted in the section above, the world’s largest asset manager has said the “lack of confidence in ESG data and ESG scores” is the single biggest challenge facing investors at this moment.
One problem is the number of ESG data providers. According to Gianfranco Gianfrate, Professor of Finance at EDHEC Business School, there are around 200 providers of ESG scores which can lead to greenwashing issues.
“Because there are so many data providers, investors are able to find one that rates the sustainability of a company even if the others do not,” Gianfrate continued. “It is like having no ESG ratings at all.”
One way investors are solving this challenge in portfolios is by selecting trusted ESG ratings providers with thorough and industry-recognised processes.
Using a consistent ESG ratings provider can also help investors take a consistent approach to sustainability across a portfolio’s exposures.
While the 200 or more providers certainly opens the door to potential issues, where investors and the European Union are most focused is around the disclosure standards for individual companies.
Firms are not required to submit ESG data to providers which can lead to big holes when being assessed from a sustainability perspective. For example, MSCI – one of the largest players in the space – takes an industry average score when there are holes in its data meaning companies can, in effect, play the system by not submitting data for metrics they know they will score poorly.
“The obvious issue here relates to quality of data which has spurred the number of acquisitions of ESG data providers,” Limberis added. “ESG data is without a doubt improving but it is still lagging in some areas like Scope 3 emissions and emerging markets.
“Consistency of ratings between data providers is still an issue which does impact the fungibility of switching between ESG ETFs that use different index providers.”
Regulation to improve company reporting standards would be a huge step as it would enable ESG ETFs to be created with more accuracy and provide investors with even more transparency when selecting which strategy to include in their portfolios.
This article first appeared in Under The Spotlight: The rise of ESG ETFs in partnership with iShares by BlackRock