Funds can die a death in so many ways. Returns can tank, a major investor can pull their money out or an asset manager can “rationalise” the fund away in favour of something more fashionable, to name some of the more common reasons. A more unconventional case crossed my desk this week, in the form of an environmental, social and governance (ESG) fund falling victim to the tightening of its own investment criteria.
As its name suggests, the Xtrackers MSCI Europe Energy ESG Screened UCITS ETF (XSER) seeks to offer exposure to stocks in the European energy sector which meet certain minimum ESG standards. However, MSCI is set to change some of the methodology for the index the fund tracks – with new ESG-driven revenue screens, additional exclusion criteria relating to environmental controversies and the introduction of an overall greenhouse gas intensity reduction target.
This appears to have made the fund unviable, with a notice to shareholders warning that such changes would result in the majority of the index’s current constituents being removed, leaving just a small number of companies for the exchange traded fund (ETF) to hold. This could translate into an extremely concentrated fund, something that might be challenging under UCITS rules. As such the fund will shut in March.
This particular fund wasn’t huge in the first place, but its closure tells us a few things. Firstly, that ESG criteria might slowly be getting stricter, a positive development – especially in the ETF space where mainstream ESG products can have material exposure to the likes of the big energy companies. As we’ve noted before, some of the stricter ESG indices can still have notable allocations to “bad” companies, but perhaps things are moving in the right direction. This ETF, for its part, had a whopping 29.1 per cent of its assets in Shell (SHEL) on 27 February, with 18 per cent in BP (BP.) and 16.1 per cent in TotalEnergies (FR:TTE).
The make-up of the fund reminds us, however, that certain companies seem almost totally incompatible with an exclusionary ESG approach. While that’s a fair enough trade-off for an investor with such leanings, the ESG lens can make portfolios less diversified. It prevents portfolios from backing certain sectors at times when they do well (that energy ETF has returned nearly 24 per cent over a year) and the ESG process tends to result in more of a focus on the quality and growth styles of investment rather than value.
So can we square the circle? Perhaps in some ways: think of the renewables trusts benefiting from the uplift in power prices in this instance. Or, more interestingly, look at those rare value funds with a big focus on certain ESG issues. To give one example BlackRock Sustainable American Income (BRSA) introduced explicit ESG criteria to its investment process in 2021. Such shifts can make a fund more concentrated but might nevertheless offer some style diversification in an ESG-friendly manner. That fund had a 22.2 per cent allocation to financials at the end of 2022, with 20.1 per cent in healthcare and 13.7 in information technology. It does have some energy exposure but claims it has a high hurdle for investment here, backing names that can “improve upon environmental issues or demonstrate clear leadership in sustainability”, as its managers noted in the trust’s last half-year report. Individual as our ESG views remain, some solutions might be out there.
