Investors continue to search for ways to express their ESG views in a more focused fashion, leading them to consider two separate but equally key points: the asset area where they’re aiming to demonstrate such views, and the specific ESG issues they want to address.
In Europe, there is a near constant stream of new ETF launches tailored to suit the evolving ESG needs of clients. Of the 40+ ESG ETFs launched so far this year, providers have incorporated ESG or climate considerations into areas such as small-cap stocks, sectors, sovereigns and even commodities.
At the same time, they’ve launched funds tracking broader asset classes, but incorporating considerations of nuanced ESG issues, such as Sustainable Development Goals (SDGs), biodiversity and climate transition.
In a recent survey of asset managers by the Index Industry Association, it was found that, on average, participants expected more than half of the assets in their portfolios to incorporate ESG elements within the next five years. Although ESG may already be firmly integrated into the core sections of these portfolios, this proliferation of ESG will see increased integration into the satellite, tactical or alternative portions of such managed assets.
Typical investments in these parts of a portfolio come with their own unique challenges. Within sectors for example concentration risk must be carefully managed alongside targeting meaningful ESG outcomes, something we’ve seen thoughtfully considered in launches this year.
In government bonds, exclusions can cause significant deviation from standard indices and there’s little room for engagement (at least, without collective action). ETFs have been launched in 2023 that tilt government bonds on climate or ESG considerations, or even look to incorporate green bonds as far as is possible, while still keeping deviation from the parent benchmark near zero.
Sector ESG funds are also notable in that they not only allow investors to manage specific sustainability risks that may be of most concern, e.g., governance issues in the financials, but also allow them to focus on specific issues, such as choosing to use an ESG fund for healthcare exposure because of concern about access in medically underserved communities.
A focus on an individual ESG issue by an investor may be motivated by either of the considerations above, i.e., a belief that the issue poses a long-term financial risk to the portfolio, or that it’s an area where the investor wants to effect change.
Notably, the vast majority of products that ETF providers offer can be used to express either view. Even recent launches that focus on individual SDGs, products that would appear to appeal more to the ‘effecting change’ end of the investor spectrum, could be useful in managing financial risk.
For instance, if you believe that new regulation may impact the ability of companies to dump effluent in rivers (SDG 6), or that there may be a tendency for groupthink in companies that limit opportunities for minorities (SDG 10), there are products available to you that could help manage these risks.
Climate strategies are not themselves new for ETFs, but the way that providers are tackling the issue is constantly evolving. The EU taxonomy includes a focus on climate adaptability and mitigation, and although some funds available tie in with the adaptation side (EVs, clean tech, etc.) most are focused on the mitigation route.
Clean energy funds offer exposure to companies active in renewable energy, but also those looking at battery solutions where they’re considering efficiency, conversion, and storage of electricity.
Commodity funds with a climate objective have also been popping up recently, from those that invest in transition metals (nickel, lithium, etc.), to broad commodity funds that aim to reduce exposure to commodities that have high emissions associated with their production.
A bounty of solutions exists for investors in the broad market climate area; however, the ways in which such climate transition and Paris-aligned funds tackle the problem varies. It’s key to differentiate between those funds driving the transition by holding companies that are actively decarbonising (say by considering constituent climate targets, transition opportunities, or exposure to solutions) and those funds that are reducing greenhouse gas emissions by only rotating their portfolio towards companies that are already low emitters.
ETF providers have long been quick to react to changing client needs, and the evolving offering in ESG is testament to this. Such client demand should continue to drive the move into smaller asset classes and a focus on specific issues.