The second edition of ETF Stream’s two-part webinar series, the Road to Beyond Beta Europe Digital, explored the innovation taking place in the ESG ETF space, the lack of consensus when implementing sovereign bonds in an ESG portfolio and the rise of climate change ETFs.

The first part of the discussion looked at the sharp rise in ESG ETF launches in Europe which jumped to a record 46 this year, as of 30 June, according to data from Morningstar, 11 more than the previous yearly record set in 2018.

Rumi Mahmood, head of ETF research at Nutmeg, said the reason for the increase in launches was due to ETF issuers simply servicing the demand for ESG ETFs.

“ESG is growing in popularity as it becomes a larger part of collective consciousness,” Mahmood continued. “It allows individuals to align investments with their personal values.

“There was a time when the use of ESG ETFs could have been seen as a box-ticking exercise where just the label mattered however nowadays investors want to know what the impact these products are having.”

ESG and ETFs: The superior approach to sustainable investing?

Furthermore, Kenneth Lamont, senior analyst, manager research, passive strategies, at Morningstar, added the increasing ESG ETF uptake from wealth managers and retail investors meant it was a great opportunity for index providers and ETF issuers to capture this demand.

While ETF issuers can charge fees for ESG products, Lamont said there were some ETFs with sustainable tilts that had dropped to the levels of the relative non-ESG equivalent.

However, Mahmood stressed there is still a liquidity premium when trading ESG ETFs, especially for recently launched products with small assets under management (AUM).

“Some sustainable ETFs might not be as easy to hedge for market makers relative to their non-sustainable equivalent so they tend to have a slight liquidity premium.

“However, we have found a consistent decrease in the spreads which is positive.”

ETF issuers not focusing on ESG are set to lose out in a big way

One of the key areas of ESG debate is in government bonds. The US, for example, has withdrawn from the Paris agreement and are one of the world’s largest weapons producers, Lamont stressed, however at what point can you remove such a major country such as the US from an index?

Furthermore, Lamont made the point that ESG indices tend to have criteria that favours higher quality countries which, arguably, need funding the least.

Mahmood added there are a number of different metrics one can measure governments on and it is not just on weapons production. For example, the UK ranks well from a human rights and governance perspective.

Nutmeg incorporates US Treasuries and UK gilts in its ESG-rated portfolios. Mahmood explained: “From a risk management perspective, government securities play a key role in a multi-asset portfolio.

“Using MSCI’s ESG data – which we do for all our ESG analysis – the UK and US scores well.”

Lamont added: “There are definitely data and construction issues that need to be answered.”

Elsewhere, climate change ETFs have exploded onto the scene this year. Lyxor, Amundi, Deka and Franklin Templeton have all launched suites this year after the European Commission’s Technical Expert Group (TEG) released two climate benchmarks; the Paris-aligned benchmark (PAB) and the Climate Transition Benchmark (CTB).

Lamont said the strategies were a positive step in the right direction by enabling investors to be exposed to the environmental segment of ESG.

Furthermore, as the ETFs follow the European Commission’s benchmark, they have given a certain level of consensus that was missing from regular ESG products.

However, Mahmood said there were flaws investors need to be aware of such as the lack of incorporation of Scope 3 emissions.

“The space does interest us,” he continued. “They seem to be providing protection against future regulatory risk.

“However, in some industries, more than 80% of business comes from Scope 3 emissions and the baskets are not conventionally easy to hedge from a liquidity point of view.”

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Finally, Mahmood said he would like to see further product development in the small-cap space. While acknowledging the data issues for many smaller companies in emerging markets, he said this would be possible in the US.

In the build-up to Beyond Beta Europe Digital event on 23-24 September, ETF Stream is hosting two webinars which will explore important areas from the factor investing and ESG landscape.