Future returns: Investing in sustainable ETFs

  • By Karen Hube,
  • Barron's
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Exchange-traded funds, often credited for democratizing investing by making broad diversification both easy and cheap, are now doing the same for environmental, social, and governance (ESG) strategies.

Ten new U.S.-based ESG ETFs were launched in 2019, bringing the total number to 85, and investors are pouring money in. Assets in these funds increased 12% last year to $9 billion, according to Morningstar. Globally, ESG assets in exchange-traded products more than doubled to $58 billion, according to ETFGI, a global ETF research firm.

The broadening field of ESG ETFs has been transformative for individual investors looking to add a socially conscious or sustainable tilt across just about all asset classes in their portfolio at extremely low cost. Investors can now use ETFs to build a diversified ESG holding not only for their core stock allocations, but across developed and emerging market stocks and fixed income.

While the first ESG stock ETF—iShares MSCI USA ESG Select (SUSA)—was introduced in 2002 and many have followed for both international and U.S. stock exposure, fixed-income ESG ETFs are new over the past two years. There are still few—just nine—with $645 million under management versus $17.7 billion in stock ESG ETFs, but high demand is keeping pipelines churning.

Finding fixed-income exposure

Core fixed-income exposure is accessible through funds such as iShares ESG U.S. Aggregate Bond ETF (EAGG) and iShares ESG 1-5Year USD Corporate Bond ETF (SUSB). One of the newest within fixed income, introduced in September, breaks out of the core: Nuveen ESG High Yield Corporate Bond ETF (NUHY), which tracks the Bloomberg Barclays MSCI U.S. High Yield Very Liquid ESG Select Index, and aims for a low carbon footprint among other ESG criteria.

“Fixed income is the next area where ESG ETF sponsors are looking to deploy product,” says Abdur Nimeri, head of institutional multi-asset programs for Northern Trust’s FlexShares, the firm’s ETF brand.

Nimeri says there’s been a dynamic shift in the conversation with advisors lately that foretells of continued expansion. “There’s not an advisor I speak to today who doesn’t bring up the question of ESG,” he says. “Three years ago, we were leading in bringing the subject up.”

Caution is warranted

Expanding options and ESG ETF’s low costs—the average expense ratio is around 0.4%—make these products an exciting on-ramp for aligning socially conscious and environmental themes to investments.

Some caution—and research—is warranted, because there is no standardization across portfolios when it comes to defining how ESG principles are applied. Just because a fund’s name indicates some sort of ESG standard, doesn’t mean its standards are high, or that it pays attention to all ESG causes equally.

“My ESG is not your ESG. It’s important that investors don’t take the labeling at face value and really dig in,” says Ben Johnson, director of global ETF research at Morningstar. “It’s incumbent upon the investors to understand how the ETF aligns with investment preferences. There’s a lot of homework to be done and more so all the time as more asset managers latch on to this trend.”

Consider sustainability ratings

A starting point is Morningstar’s sustainability ratings, which help investors size up how well—or poorly—a portfolio is adhering to ESG principles relative to its peers. Introduced in 2016, these ratings provide a snapshot through numerical scores: 0 to 19.99 represents an admirable low-risk score; 30 or higher are reserved for the least green and clean portfolios.

Consider one of the newest and most popular ESG stock ETFs, Xtrackers MSCI USA ESG Leaders Equity ETF (USSG), which has drawn $1.7 billion since being introduced in the third quarter last year. The fund has an ESG risk score of about 22—about moderate—but a better-than-average overall sustainability rating by Morningstar relative to its category. With an expense ratio of .10%, the ETF aims for the same risk-reward profile as the MSCI USA ESG Leaders Index, while excluding alcohol, weapons, and other controversial companies and emphasizing those with high ESG ratings.

While many funds will create negative screens for companies with objectionable practices, the emphasis of ESG is more about selecting the best in class—even in industries that have controversial records. For example, in the energy industry, rather than screening out the sector altogether due to practices that can contribute to environmental problems, companies with the best records are selected.

“In energy, we look at the universe and choose securities that are in the top 50% of our metrics relative to peers, not relative to other industries,” Nimeri says of Northern Trust, which has two ESG ETFs: FlexShares STOXX U.S. ESG Impact Index ETF (ESG) and FlexShares STOXX Global ESG Impact ETF (ESGG).

As for performance, the only certainty about an ESG-focused ETF’s performance is that it will perform somewhat differently than its benchmark. Last year, U.S. stock ESG ETFs posted a 27% average return. The ETFs, because they are carefully constructed to mimic but differ from their benchmarks in composition to tilt toward ESG criteria, are considered to be actively managed funds. Says Morningstar’s Johnson, “Whenever it’s some form of active management, some will do well and some will perform poorly.”

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