When ethical ETFs aren't ethical

Earlier this month, iShares launched iShares Sustainable MSCI Emerging Markets SRI UCITS ETF (SUSM) and iShares Sustainable MSCI USA SRI UCITS ETF (SUAS), taking the number of ethical ETFs on the London Stock Exchange to 18. But progress has been slow and, so far, iShares and UBS are the only providers to have made a real push into the area.

That could be partly due to the difficulty of defining what makes a socially responsible, or ethical, ETF.

The most common ethical indices tracked by London-listed ETFs are MSCI's Global socially responsible investing (SRI) indices. ETFs tracking them include UBS MSCI Japan SR UCITS ETF (JPSR), the new iShares ETFs and UBS MSCI Pacific SR UCITS ETF (UB45). The indices are made up of equities that score highly on a range of 37 different environmental, social and governance (ESG) metrics, including governance, pollution and waste, and social opportunities. They exclude stocks engaged in eight activities, including alcohol, gambling and tobacco.

The Dow Jones indices used by London-listed ETFs - Dow Jones Sustainability Europe and Dow Jones Sustainability World Enlarged Index ex Alcohol, Tobacco, Gambling, Armaments & Firearms and Adult Entertainment indices - are designed to prioritise 'best-in-class' stocks obtaining the highest ESG scores, while excluding companies engaged in what are deemed to be unethical industries.

But companies that you may not consider ethical could still appear in these indices and ETFs . For example iShares Sustainable MSCI Emerging Markets SRI UCITs ETF (SUSM) holds Korean oil company S-Oil, as well as Hungarian oil company MOL (MOL:BUD) and Thai Oil (TOP:SET).

A number of major airline operators are also included in this index. iShares Sustainable MSCI Japan SRI Eur Hedged UCITS ETF (SUJS), meanwhile, has a substantial exposure to utilities.

When ethical ETFs aren't ethical

There are also instances where an ethical ETF could hold the stocks it is designed to exclude. Amundi ETF MSCI World Low Carbon (LWCU) is a synthetic ETF, so it doesn't hold the assets in an index but enters into an agreement with a third party to receive the returns of a given index in exchange for the returns of a basket of collateral it holds. Although the constituents of the index it tracks are screened for carbon emissions, the basket of collateral it holds is not. According to Morningstar, this has included Belgian brewer Anheuser-Busch InBev (ABI:BRU) and German pharma-giant Bayer (BAYER:BUD), which have been specifically excluded from the underlying index because of their relatively large carbon emissions. Morningstar does not include synthetic ETFs in its new sustainable fund ratings for this reason.

"It does not make sense to have swap-based SRI ETFs because you get the returns of the SRI index but don't get the holdings, which is the whole point," says Irene Bauer, chief investment officer at Twenty20 Investments.

ETFs that engage in securities lending, such as the majority of UBS's range, could also leave you holding unethical stocks. Securities lending is a practice whereby physical ETFs lend out their holdings to a third party to boost returns. The ETF receives a basket of stocks as collateral and these are not subject to the same rules as the index. This is likely to be a small chunk of the ETF but is something to be aware of when looking at your holdings.

When ethical performs better (and when they don't)

There is no one reason why SRI ETFs should perform differently to their comparative non-filtered ETFs. But if successful companies are excluded from the ethical indices these ETFs will lag. This is true of MSCI's US SRI index, which does not have exposure to Apple (AAPL:NSQ), despite its large representation in MSCI USA. Over three years iShares MSCI USA UCITS ETF (CSUS) has returned more than 56 per cent while UBS ETF MSCI USA Socially Responsible UCITS ETF (UC46) has returned 41.7 per cent.

"If suddenly everybody wants to drink and smoke, then those stocks will go up and these indices will perform less well," says Ms Bauer. "But generally they tend to perform well and quite often have even done better than their comparable [mainstream non SRI] indices."

That is true of UBS MSCI EMU Socially Responsible UCITS ETF (UB39), which has outperformed UBS MSCI EMU UCITS ETF (UB06) by a substantial amount over one year, returning 11.04 per cent compared with 4.3 per cent. But over three years it has lagged UBS MSCI EMU UCITS ETF.

Ethical ETFs listed on LSE

Source: Morningstar, as at 6 July 2016