Over the past years, ESG (Environmental, Social, and Governance) exchange-traded Funds (ETFs) have seen tremendous growth. As of 2022 global ESG ETFs manage a staggering total of $378 billion according to Statista.
While there are a plethora of ESG ETFs available, we want to delve into how to use them to construct a sustainable ETF portfolio and also look at the risks and controversies of ESG ratings.
What are ESG ETFs?
ESG ETFs are, as the names suggest, ETFs which focus on investments with superior Environmental, Social, and Governance standards. Typically, those ETFs focus on shares and stocks, but also bonds can be selected based on ESG criteria.
Using ESG ETFs, investors can construct a portfolio which allows for greater portfolio diversification with an investment in just a few securities, while still adhering to sustainability standards.
In addition to providing a simple way of diversifying one's portfolio and a broad array of investments, ESG ETFs may also be an option to increase one's returns, if one believes that sustainability is linked to higher stock price performance.
Who rates ESG Indices and ETFs?
In order to create an ESG ETF, an ETF issuer needs to define criteria to select the correct investments. ETF issuers, however, rarely do this work themselves, that is why ESG ETFs typically track an ESG Index which is separate from the well known and widely followed stock Indices such as the S&P 500.
Index providers such as S&P or MSCI, therefore, create separate ESG Indices which are based on ESG criteria while at the same time seeking to provide a well-diversified market exposure. As a result, ESG indices may include companies which at first glance may not appear sustainable such as the oil & gas sector. However, typically there is some rationale for why a particular company may be included, such as being the best oil & gas company in class for governance and social factors.
Investors who seek to align their capital with sustainability can refer to ESG indices powered by different ESG rating agencies. Some of those rating agencies are well-known Index providers themselves, such as MSCI and FTSE Russell, whereas others are financial data providers or specialised ESG rating companies such as Refinitiv, ISS ESG, and Sustainalytics.
Each rating agency employs its own framework and methodology to assess the performance of companies on environmental, social and governance fronts.
All the agencies use a range of frameworks, indicators, and data points to calculate the ratings. These ratings are expressed in two forms – letter grade or numeric scales and are designed to measure relative or absolute ESG quality.
Marketscreener provides a free overview of stocks rated by Refinitiv on ESG criteria.
Controversies about ESG ratings
Despite the popularity and sensible idea of ESG criteria to improve corporate governance by including them as investment selectors, ESG is not universally popular and has attracted some controversies.
One of the core criticisms levelled at ESG ratings is their lack of standardisation, transparency and potentially biased procedures used in the rating process.
Tobacco company Altria has recently announced that it is on the road to becoming an ESG stock whereas Tesla is scoring poorly, leading to a backlash against ESG ratings by Elon Musk, its founder.
Further, the costs associated with ESG ratings – which typically get passed on to sustainable investment customers in the form of higher management fees – can compromise potential returns, rather than benefit the bottom lines of asset managers.
Steps to construct an ESG ETF portfolio
If you are interested to construct a portfolio using ESG ETFs and sustainability criteria, you can use a step-by-step process to select your investments:
- Identify your objectives: First, think about what it is you care most about – be it climate change, human rights, or corporate governance. Based on this selection, you can narrow down whether you want to invest according to broad ESG criteria or perhaps more focussed on ETFs which focus on technologies to combat climate change.
- Choose a strategy: Decide on the strategy approach you want to take in implementing your investment priorities – whether that’s an exclusionary approach that avoids certain industries (e.g. if you were focussing on climate change) or a more general positive screening approach which prioritises companies with good ESG standing, regardless of their industry.
- Secure your risk levels and asset allocation: Use an online questionnaire or speak to a financial adviser to determine your target risk tolerance levels and asset allocation. Based on this, then select suitable ETFs across asset classes, sectors, and geographies that match your risk tolerance and ESG criteria.
- Screen your ESG ETFs: Evaluate your ETFs based on their tracking error against the index and fees and expenses. It is particularly important to take a look at the total expense ratio (TER) of each ETF, as these can diverge widely. The TER measures the cost of holding the ETF each year and is usually given in per cent or basis points. It can range from less than 0.1% for index-tracking ETFs to more than 1% for specialised niche ETFs. Insofar, to keep a close eye on these costs as they are a big contributor to the performance of the portfolio.
- Monitor and readjust: Keep an eye on the performance of your portfolio and tweak your investments as needed to keep your ESG priorities and target asset allocation in check.
By investing in ESG ETFs, you can create a portfolio that’s aligned with your values, build a resilient long-term portfolio, and promote responsible investing at the same time.