Just like the debates around active versus passive funds or the definition of smart beta, the concept of environmental, social and governance-focused ETFs is hotly debated.
ESG has come a long way. What started in the 1960s as stripping out tobacco stocks has evolved to other areas like gender equality, green bonds, social impact investing and more. ESG, to a certain extent, has also had to keep abreast of societal changes, removing increasing numbers of stocks and sectors as time goes on, from companies that derive most of their revenue from arms sales to companies that benefit from practices such as child labour.
Arguably, this method of building an ESG portfolio – called negative screening and the most popular form of ESG portfolio construction in Europe – is easy to implement, and it can be adapted according to a client’s mandate. But what ETF providers are increasingly interested in doing, which is building an index and therefore a fund from the bottom up in a green manner, brings its own challenges: namely, how to decide what is “ESG” and what is not.
That answer will always come back to the subjectivities of the client, or the ultimate decision of the indexer or asset manager. The UK economy has made money and employed people by selling arms abroad, so is investing in that sector a bad thing? Is it a morally upstanding act to support companies that promote more women to their boards, or is it better to call for a ‘meritocracy’?
Then there is the question of imposing western values on the rest of the world. (That’s one reason ETF providers and asset managers are increasing their ESG teams abroad, so they have feet on the ground and can make decisions that are appropriate to the culture and values of that market.)
Religion also provides a separate category of ESG, from a so-called Catholic Values ETF to ETFs that abide by Shariah law, which includes no conventional banking, pork-related products, alcohol, non-halal food, gambling, pornography and weapons. But even in the most orthodox of financial products, there may have to be compromises in order to create a viable and diverse investment proposition. Interestingly, a Shariah-compliant ETF which launched in the US in July only excludes any company from the fund that derives more than 5% of its revenue from a company or sector that prohibits Islamic principles.
Identifying ESG is not for the faint hearted. MSCI, which claims the most assets tracking its ESG indexes compared to any other indexer, has an ESG rating system which involves no less than 10 categories, from climate change and pollution and waste to corporate governance and stakeholder opposition.
It’s much easier to define smart beta, in fact. An equity risk factor, or the construction of an index, cannot invite argument. And while there are certain ESG factors which do not need to be questioned – a textile manufacturer pollutes a local river or it doesn’t, and a tech company exploits its factory workers in China or it doesn’t – but other areas, as explained, can be subject to interpretation and individual beliefs.
But as time moves on, less will be subject to interpretation and more will be enforceable by law. In fact, the European Commission has required asset management firms to direct their attention to sustainable technology and business, as well as to contribute to the creation of a low-carbon economy – all part of the target to reduce carbon emissions by 40% by 2030, as set out in the Paris Agreement and the United Nation’s Sustainable Development Goals.
In 2019, investors have increasing options for funds and portfolios that align with ESG views. As long as you are clear what you’re investing in and why you’re doing it, the rest is up to you.