What ETF investors should know about ESG

A review of ESG ETF scores and methodologies used in the industry reveals some pitfalls and trade-offs

What ETF investors should know about ESG

With the growth of ESG and the explosion in ESG ETFs, conducting proper due diligence on responsible-investing products is more important than ever. Those with a keen interest in the trend are likely on the ball already, keeping an eye on the various resources that have mushroomed in support of this trend.

But even as their asset allocation and investment selection is already well-informed with such data, there is still a lot of opportunity for improvement. As noted by Ben Lavine, CIO of 3D Asset Management, in a recent piece for ETF.com, it is important to understand the biases built into an ESG program “beyond the direct themes stated in the prospectus or investment policy statement.”

A deep look at ESG fund ratings

While there’s still much work to do in terms of standardizing ESG data, Lavine acknowledged that data researchers have made significant strides in developing ratings methodologies that focus on material financial risks. Such data, he added, is used by fund intelligence firms to create aggregate ESG ratings at the fund level.

“Currently, the ‘ESG fund category’ is somewhat nebulous given that ESG can encompass both qualitative themes (e.g., clean energy) and traditional market-based approaches (e.g., the MSCI ESG Indices),” he said.

ESG fund ratings are based on scores across three categories: environmental, social, and governance. According to Lavine, ESG category fund scores tend to be highly correlated — a fund that scores high in one category is likely to also have high scores in the other two — “suggesting a fair degree of intersectionality across ESG.” It raises a question, he said, of whether there’s a methodological bias at play when it comes to scoring.

Finding the best ESG fund segments

Referring to an analysis of US-listed ETF data from Morningstar, Lavine said that some interesting trends arise when it comes to how different categories of funds fare in ESG.

One interesting observation is how European-focused funds tend to garner top scores — “Europe largely berthed the ESG movement and has pretty much mandated it across a significant portion of the investor base,” he noted. Meanwhile, emerging-market funds, particularly those in China and India, tend to score at the bottom.

There was also a tendency for large-cap funds to score better than midcaps, and for midcaps to do better than small-cap funds. The poor performance of small-cap products — they tended to have worse scores than emerging-market funds, Lavine reported — might be explained by the limited scope of data coverage across the small-company universe, as well as large companies’ likely greater ability to shoulder greater compliance and monitoring costs related to ESG.

Lavine also stressed that some asset allocators, in order to avoid the risks of having a small pool of companies or funds to choose from, might adopt a relative approach rather than an absolute one in constructing their ESG portfolios. As a consequence, the ESG impact that clients may wish to achieve may get blunted in favour of more risk- or return-oriented considerations.

“At the very least, advisors should disclose and explain these trade-offs with those clients seeking to incorporate ESG principles into their programs,” he said.

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