Introduction

Environmental, social and governance (ESG) ETFs invest in secures that adhere to specific sustainable principles. 

Unlike traditional ETFs, which might focus solely on financial performance, ESG ETFs also consider the environmental and ethical implications of their investments. 

Indices that ESG ETFs track are screened on a variety of sustainable criteria which vary in degree of ‘greenness’ depending on the investment strategy. 

The ‘environmental’ pillar in ESG covers evaluations of a company’s impact on climate change, natural resources, pollution and waste, as well as sustainable opportunities.

‘Social’ covers human capital, product liability, stakeholder opposition and social opportunities while ‘governance’ looks at metrics including diversity, corporate behaviour and transparency.

ESG pillars

The construction of an ESG ETF starts with the application of ESG screening criteria to an index. The ETF issuer will consider the three ESG ‘pillars’ as part of its security selection and allocation methodology.

ESG indices are often derived from a standard market-cap-weighted index such as the S&P 500.

The depth of ESG integration can vary widely among ETFs. Some ETFs apply a light ESG filter while others adopt a more stringent approach, actively seeking out companies with the best ESG scores in their respective industries.

The first stage of constructing any ESG index will be to remove any securities of companies involved in what the index provider has defined as controversial activities or industries, which typically includes companies engaged with controversial weapons, coal and tobacco.

The ‘lightest’ best-in-class approaches may aim to capture around 75% of the parent index whereas the ‘strictest’ versions could aim to capture only the top 25% of the market weight, based on ESG scores.

In Europe, the European Commission introduced the Paris-Aligned Benchmark (PAB) and Climate-Transition Benchmark (CTB) to offer clear insights into how indices can aim to meet goals related to reducing greenhouse gas emissions and transitioning to a low-carbon economy.

ETFs tracking PAB and CTB are categorised as Article 9 – often referred to as ‘dark green’ – or Article 8 – commonly known as ‘light green’ – under the Sustainable Financial Disclosure Regulation (SFDR).

Different

ESG ETFs can be broadly categorised into three categories. Broad ESG ETFs invest in a diverse array of companies from various sectors that adhere to general ESG criteria, tracking indices focused on the ESG performance of the companies.

Thematic ETFs focus on particular sustainability themes such as clean energy or water conservation, which offer a more targeted way of ESG investing.

Finally, sector-focused ESG ETFs target specific sectors or industries known for strong ESG practices.