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How ethical is your ESG ETF?

It is important to look at ESG ETFs' top holdings and sector exposures to make sure they meet your ethical preferences
How ethical is your ESG ETF?
  • The ETF space is awash with ESG products but the investment criteria behind them can vary significantly
  • There are some big differences behind the approaches on offer

Active managers may have spent a busy year trying to burnish their environmental, social and governance (ESG) credentials, but investing in this space is not merely the preserve of the stock picker. Passive funds have their own role in the ESG space, and plenty of these have a large following - from the popular iShares Global Clean Energy UCITS ETF (INRG) to “good” versions of conventional market indices such as the S&P 500.

ESG versions of traditional trackers have much of the appeal of other passives - they provide cheap, diversified exposure to a market. But those who use them should always check what exposure they are signing up for because when it comes to ESG ETFs, index composition can result in some notable differences.


“Light” ESG

The indices that ESG ETFs track can differ greatly in terms of how strict their criteria are. Some “light” ESG indices will simply screen out those industries perceived as having a particularly negative impact. Some of the Legal and General Investment Management ETFs included in 2020’s IC Top 50 ETFs list, for example, take a “light” approach and just screen out the worst offenders on ESG issues.

L&G UK Equity UCITS ETF (LGUK) is not explicitly labelled as an ESG product but tracks the Solactive Core United Kingdom Large and Mid Cap index, which screens out companies engaged in pure coal mining or the production of controversial weapons, as well as businesses classified as having breached at least one of the UN Global Compact principles for a continuous period of three years.

Light ESG ETFs are broadly similar to their conventional counterparts. Latest disclosures from the LGIM ETF, for example, suggest that it differs only slightly from a conventional UK tracker fund. Like iShares Core FTSE 100 UCITS ETF (ISF), it recently had roughly 9.5 per cent of its assets in the energy sector. The two ETFs' top 10 holdings differed mainly in the amount invested in specific stocks rather than the ones included. Both ETFs held the likes of British American Tobacco (BATS) and Royal Dutch Shell (RDSB)

Investors who would rather not exclude too much of a market may see the appeal of “light” ETFs. But they should not be held as ESG options alongside conventional ETFs, given that the two are so similar.

The LGIM funds are relative newcomers to the industry but some more established ESG ETFs can also find themselves tracking an ESG index that looks fairly similar to its conventional equivalent. iShares offers MSCI ESG screened ETFs for certain markets which can often look much like the original index. As iShares puts it, they are “designed for investors looking to screen out controversial business areas while maintaining a risk profile similar to traditional benchmarks”.

Briegel Leitao, associate analyst for passive strategies at Morningstar and an IC Top 50 ETFs judge, notes that lighter ESG indices can focus on underweighting "nasty" stocks but they should not be expected to take big sector bets.

"Buying an ESG index from MSCI doesn’t necessarily mean you’re taking large underweight bets on energy or industrials - just that you’ll be investing in the ‘best’ of what’s left after screens," he says.

Some alternatives can be worth considering if you wish to take a stricter approach. Xtrackers MSCI UK ESG UCITS ETF (XASX) tracks the MSCI UK IMI Low Carbon SRI Leaders Select index, which targets UK stocks with “high ESG characteristics and low carbon exposure, relative to their peers”. It has a notably different composition to the other UK ETFs mentioned, with just 0.21 per cent of its assets in the energy sector in late January. Royal Dutch Shell and British American Tobacco were absent from the fund at the end of January.


“Stricter” ESG and the problems of methodology

Like the Xtrackers fund, many of the stricter ESG passives have a focus on socially responsible investing (SRI). MSCI’s SRI range is seen as having a stringent process in that it seeks out the best companies as judged by the relevant metrics. Leitao highlights MSCI's SRI Low Carbon Leader and SRI Low Carbon Select 5% index ranges as standout options.

As with any fund in this space, you may find holdings that do not conform to your idea of an ESG investment. Take the Xtrackers ETF: while it excludes some of the big oil and gas names, mining giant Rio Tinto (RIO) was included in its top 10 holdings at the end of January making up 6.7 per cent of the fund. Similarly, this fund had a higher allocation to the industrials sector than the iShares FTSE 100 ETF.

Avoiding certain parts of the market can also force a fund into bigger positions elsewhere. Xtrackers MSCI UK ESG UCITS ETF had especially big bets on specific companies, with 11.8 per cent in Unilever (ULVR) and 10.4 per cent in AstraZeneca (AZN). This can create greater individual company and sector risk.

A good number of ETFs use MSCI for ESG versions of conventional trackers, meaning its index ranges are worth investigating. As with active funds, the investment criteria can be important in markets dominated by companies that are, in the view of some, controversial holdings.

Take the US, where the FAANG stocks - Facebook (US:FB)Apple (US:AAPL)Amazon (US:AMZN), Netflix (US:NFLX) and Alphabet (US:GOOGL) are major market constituents. As we discussed last year [IC 27.03.20], active fund managers can have different views on which of these stocks fit into an ESG portfolio. The same applies to passives: iShares MSCI USA UCITS ETF (CU1) recently listed Apple, Amazon, Alphabet and Facebook among its top 10 holdings. Yet none of these names appeared in the full list of holdings for the SRI equivalent, iShares MSCI USA SRI UCITS ETF (SUUS). This can be extremely important, both in terms of investors' ethical views and performance. iShares MSCI USA SRI UCITS ETF actually slightly outperformed iShares MSCI USA ETF last year - despite a lack of exposure to the FAANGs.

This, however, stems in part from a bigger bet the SRI fund has. As we recently noted [IC, 19.02.21], Tesla (US:TSLA) tends to be absent from many ESG funds but MSCI’s SRI USA and World indices do include it. This means that iShares MSCI USA SRI UCITS ETF had a 4 per cent position in the electric carmaker on 26 February, compared with iShares MSCI USA UCITS ETF's 1.5 per cent weighting to it. While Tesla’s meteoric share price gains will have boosted returns in 2020, investors might have qualms about both the company’s governance and its large investment in bitcoin, whose processes are extremely harmful for the environment.

As such, it is always worth digging into an ESG ETF’s top holdings and sector exposures. The high levels of disclosure in the ETF space mean that you can often look at a full list of holdings, allowing you to truly assess whether the fund matches your ethical ideals.