Roundtable ‘Sustainable ETFs’

December 21, 2023

 

CHAIRMAN Marc van Maarle, Index People   Participants: Effi Bialkowski, Van Lanschot Kempen Monika Calay, Morningstar Rebecca Chesworth, State Street SPDR ETFs Frédéric Hoogveld, Amundi Philippe Kybourg, UBS Asset Management Alexandra Melhuish, J.P. Morgan Asset Management Joris Roggeveen, Goldman Sachs Asset Management

 

In 2022, MSCI World Leaders achieved a return of minus 14.3%, while the standard MSCI World achieved a return of about minus 12.8%. In addition, the US state of Texas, for example, is initiating all kinds of anti-ESG initiatives. Moderator Marc van Maarle opened with these current events.

Will this negative news affect demand from global end-investors and the supply of providers of passive ESG investment solutions?

Joris Roggeveen: ‘This is not a trend, but a structural change in our industry to move to sustainable investing. Everyone has their own thoughts on how to integrate or implement ESG, or to what extent ESG factors should be considered. However, I think the majority of asset owners and asset managers are taking the structural path of ESG or SRI: that is the way forward.'

Monika Calay: ‘There are two main areas to consider: performance and politics. In terms of performance, recent research from us shows that ESG funds, despite the challenges in 2022, showed resilience in their medium- and long-term performance. Our analysis, which compared the average returns of ESG funds and traditional funds as of 2022 and over the past three, five and 10 years, shows that ESG funds did not lose performance in the medium to long term. On average, ESG funds outperformed their non-ESG counterparts over these timeframes. Politically, while anti-ESG sentiments have emerged, such as in Texas, our research shows that assets in anti-ESG funds are only about $2 billion, suggesting it is not a widespread trend. Despite the challenges of 2022 and some doubts about ESG, the data highlight a promising trajectory for ESG funds in the longer term.'

Effi Bialkowski: ‘Recent disappointing returns for ESG funds can certainly influence our clients’ choices. However, we think this will affect the short term and not the longer term. Sustainable investing is a long-term strategy, though.'

 

Marc van Maarle Marc van Maarle is Senior Institutional Asset Manager at Index People and has over 25 years of experience in (institutional) asset management and corporate treasury. He has worked at Index People since 2014 and is ultimately responsible for all investment and related operational matters for institutional clients. He is also chairman of Index People's investment committee.

 

Rebecca Chesworth: ‘I tend to think that clients are less concerned about the performance of ESG funds because it is not necessarily why they bought those funds. There is perhaps more doubt - I prefer to use the word scepticism - about ESG investing, particularly because of the confusion over labels. On top of that, we have to worry about geopolitical developments and things like artificial intelligence, for example.'

Frédéric Hoogveld: ‘Over the long term, the performance of ESG strategies has been pretty good. As for whether scepticism has arisen among ESG investors, we see that this is indeed the case in the United States: both asset owners and asset managers are taking a step back with regard to ESG there. We do not see this among European and, to some extent, Asian investors.'

Philippe Kybourg: ‘If we only look at equity ETFs, we see that the share of inflows into sustainable ETFs is up to 40 per cent this year. So when people say there is less demand for sustainable ETFs because of poor performance in 2022, I think if we look at the numbers, the opposite is true.'

Alexandra Melhuish: ‘Investors are naturally concerned about recent performance, which is justified given the past few years. However, there are clear structural shifts underway that are positively affecting the outlook for many companies that can be found in sustainable ETFs - such as the US inflation-lowering bill or the focus on energy security in Europe that supports investments in renewable energy. While we recognise the challenging background of recent years for sustainable strategies, we also want to ensure that our clients take into account the potential future opportunities in this area.'

Strict ESG-based investing would mean investing only in rich countries, neglecting ESG's goal of promoting sustainable development.

Each fund provider not only meets minimum legal requirements, but also has its own vision of sustainability. This makes it difficult to put together a well-diversified portfolio on which a unified methodology or ESG screening is based. On 13 June, the European Commission came up with a proposal to make ESG ratings from ESG data providers more reliable and comparable.

Is this proposal a good development, or is diversity in outcomes actually better as investors will have more to choose from?

Melhuish: ‘The divergent interpretations of the term “sustainable investments” among fund managers can create problems for fund distributors who want to align their approach with clients’ expectations. While there is growing acceptance of different ways to invest sustainably, it does mean that distributors need to perform an ‘additional layer’ of due diligence on the investment universe, to make sure they know what they are investing in and whether this is in line with their own interpretations of sustainability.'

Roggeveen: ‘Diversification in the product range is obviously good for investors, as there will be more to choose from. We think many asset managers will also move in this direction and develop new and better sustainable strategies.'

Hoogveld: ‘I think we need competition and diversity, because some data providers mainly look at environment (environmental) and have sophisticated technology for that, while others have a very sophisticated approach to analyse social (social issues) and governance (governance). So it is important to diversify, but it is also logical for the regulator to start regulating providers that are not subject to some kind of supervisory authority.'

 

Effi Bialkowski Effi Bialkowski is Portfolio Manager and Investment Fund Specialist at Van Lanschot Kempen. She moved from Germany to the Netherlands at the age of 25 and started as a trainee at ABN AMRO. In 2000, she joined Staalbankiers as a Private Banker and Investment Advisor. Since the end of December 2016, Bialkowski has been working at Van Lanschot Kempen.

 

Kybourg: ‘As ESG data is increasingly used, it makes sense to regulate ESG data providers. Regulators will increasingly look at these companies, waiting to see if regulation is properly implemented and creates more clarity for end investors.'

On the retail side, there is demand for products in conventional arms. Can weapons ETFs be part of a sustainable fund offering from banks?

Bialkowski: ‘We offer our clients investment solutions with different levels of sustainability. Investing in weapons does conflict with our strictest sustainability policy. Customers who choose another investment solution from us can invest in conventional weapons, though. In fact, as of today, we do not have a ‘pure’ weapons ETF on our advisory list.'

Chesworth: ‘It is good to talk about this, because the concepts of ESG and sustainability should not be set in stone. On the question of weapons, it's a bit like with energy security versus renewable energy.'

Roggeveen: ‘I think each bank or each customer has the freedom to decide for itself whether to invest in products and whether to offer funds that still invest in conventional weapons or not. Times are changing and I can imagine that some investors or banks do not want to exclude conventional weapons in ETFs on their platform.'

Sustainable funds often have concentration risk, so they may be less well diversified regionally and/or sectorally.

Kybourg: ‘Conventional weapons have become a standard exclusion for ESG products. However, the impact of such exclusions on tracking error is limited.'

What are some of the risks of investing in sustainable ETFs? How can investors assess and manage these risks?

Kybourg: ‘I think it's about understanding the objective behind the sustainable fund and the index methodology of the benchmark and how it can affect not only the ESG profile of the fund, but also its risk and return characteristics. That's what we try to focus on with our clients so that they can make the best investment decisions based on sound information.'

Melhuish: ‘I don't think clients are always aware of exactly what SRI ETFs look like “under the bonnet”. To incorporate SRI, you have to reduce the number of companies in the SRI-filtered MSCI global index to around five hundred companies. This adds additional concentration risk in the top 10 companies that are also held. Investors should be well aware of these kinds of distortions inherent in some SRI ETFs. By taking an active approach, some of these risks can be mitigated through the construction process.'

Roggeveen: ‘SRI investing is often limited to the top 25%, sometimes even the top 10%, of a global benchmark like the MSCI World Index. Then you get a relatively concentrated portfolio with, of course, a high tracking error. Almost all our clients want a sustainable portfolio and to be able to compare it to a standard benchmark. Fortunately, many smart people work at asset managers, index producers and manager selection teams. They know how to construct a sustainable index with low tracking error. Incidentally, when constructing your portfolio and selecting an asset manager, you need to think carefully about what data you use in combination with investment due diligence, operational due diligence and ESG criteria.'

 

Monika Calay Monika Calay is Director of Research at Morningstar, where she leads the EMEA research team on passive strategies. She has worked there since 2021 and previously from 2015 to 2018 as Passive Strategies Analyst. From 2018 to 2021, she was employed at Vanguard, including as Portfolio Consultant. She started her career at Bloomberg. Calay holds an MSc in Data Science from University College London.

 

Bialkowski: ‘Sustainable funds often have a concentration risk and so may be less well distributed regionally and/or sectorally. You saw that in the returns last year. How do we deal with this kind of risk? For instance, we work with fund managers and build sustainable funds with them, with our own sustainability criteria and the spread we want.'

Calay: ‘There is a trade-off between strong ESG characteristics and portfolio diversification. In general, high ESG exposure means higher tracking error away from market capitalisation, which is a key risk that many of our clients are trying to manage.'

Hoogveld: ‘When it comes to ESG, there are two other non-financial risks to keep in mind. There is something I would call complexity risk, in the sense that we are seeing that indices, especially ESG and climate indices, are becoming more and more complex. On climate, we now have strategies that are much more complex because they combine different data, concepts and optimisations to build an index, for example. The fact that different providers of sustainable products have different views on what sustainability is also poses a risk. You have to be able to explain that to the customer. That is why we also welcome the arrival of ESG regulations in this area.'

Melhuish: ‘Data providers have a lot of influence, as a large part of the ETF market relies on their ESG ratings of companies. When using external data suppliers, we believe it is essential to carry out thorough due diligence to make sure we understand their methodologies.'

Clients are less concerned about the performance of ESG funds because it is not necessarily the reason why they bought those funds.

We have seen both companies and governments playing an increasing role with green bonds in the race to net zero. What feels like the right due diligence to consider at the index level and at the ETF level?

Melhuish: ‘There is currently no enforceable standard for green bonds, for example, in terms of where the proceeds go. This can lead to an increased risk that yields are not truly aligned with sustainable activities. While increasing regulation and globally aligned standards will help, there is no substitute for using active insights and performing thorough due diligence on each issue to ensure it is aligned with each investor's own sustainable objectives.'

Roggeveen: ‘With regard to green bond standardisation, ESG data and ESG criteria, there is no one big, clear outcome. It is a constantly evolving thing; there will never be a complete taxonomy. There will hopefully be more clarity and transparency, though.'

Kybourg: ‘You have to check that the issuer of green bonds at least follows certain ESG standards and/or is not involved in certain controversial business activities. Issuers that do not properly consider ESG risks may be less credible when it comes to their green bond framework and how they select and finance climate-related projects.'

Bialkowski: ‘The green bond market is still developing now and will change in the future. Besides obviously examining the projects funded with green bond proceeds and the bond issuers, it is also good to look at the stability of a fund. You also don't want to invest in a fund that has a completely different country or sector allocation after a while because of developments in the green bond market.'

 

Rebecca Chesworth Rebecca Chesworth is Senior Equity Strategist at State Street Global Advisors, where she joined in 2016 and worked with SPDR's ETF Strategy & Research team. She writes the SPDR Sector & Equity Compass and is responsible for the quarterly Sector Picks. Chesworth regularly appears on industry conference panels and TV programmes.

 

Hoogveld: ‘We check whether green bonds contribute positively to a social or environmental objective, to avoid greenwashing.’

Calay: ‘There are different types of sustainable bond funds: green bonds, social bonds, sustainability-linked bonds and so on. From a due diligence perspective, it is important to understand what exposure you get through a sustainable bond fund. The performance of green bonds was mixed in the period to 2022. We noticed that, given the long-term nature of many green bond projects, many green bonds had longer maturities. This made them more sensitive to interest rate changes. We also found that green corporate bonds leaned more towards the real estate sector, which is also sensitive to interest rate fluctuations. On the other hand, they are under-represented in the energy and basic materials sectors. Investors performing due diligence need to understand the sectoral composition and the potential risks associated with it.'

There are currently more than 700 sustainable ETFs available to European investors.

What criteria are important to consider in the investor selection process?

Bialkowski: ‘In addition to our usual criteria, we also look at climate policy,_carbon savings, the fund's impact on SDG targets, exclusion policy and the method of engagement. The relatively new sustainable investment percentages are now also taken into account when assessing investment funds.'

Choosing a climate benchmark as a strategy benchmark is difficult.

How do you ensure that choosing the right sustainable solution fits within the portfolio's overall strategic allocation?

Roggeveen: ‘We usually see asset managers creating a sustainable strategy with the default benchmark in mind. Together with your client, you can determine how much the risk tolerance is and to what extent your client wants to implement ESG factors. You have to balance these decisions together.'

Bialkowski: ‘In general, our most sustainable portfolios have the same strategic allocation as the less sustainable model portfolios. However, there are some exceptions: for example, the most sustainable portfolios are not invested in gold or commodities.'

Hoogveld: ‘We want clients to look for sustainable products across the investment spectrum. We try to launch net zero solutions wherever we can. This is where education comes in and where the discussion with the customer takes place. In the Netherlands, for example, we know distributors who say they cannot invest in US Treasuries because they do not think the United States is a sustainable country. This is not everyone's opinion, so that makes it difficult. We don't have the necessary building blocks or we don't have building blocks that everyone considers sustainable.'

Calay: ‘It is essential to get to the bottom of what customers are trying to achieve. That means asking a lot of questions to understand what their objectives are and then coming up with solutions that meet their needs. For example, we hear many clients say: I want higher ESG exposure, but I also don't want to deviate from market capitalisation. But then they don't realise that with high ESG exposure, the tracking error will be higher. So you have to understand what clients are comfortable with in order to come up with possible solutions.'

 

Frédéric Hoogveld Frédéric Hoogveld has been Head of Investment Specialists and Market Strategy, ETF, Index and Smart Beta at Amundi since 2022. Prior to that, he headed the Amundi ETF Product Development and Specialists team. Previously, he worked as a Quantitative Analyst for a number of asset managers. Hoogveld holds an Msc in Engineering (Nantes), an Msc in Corporate Finance (La Sorbonne) and an MBA (INSEAD). He is a CFA and CAIA charterholder.

 

Kybourg: ‘Our approach is to work with customers as much as possible to find the right solution that best suits their needs. This includes looking at whether there might be market dynamics that could lead to unintended consequences. For example, if a SRI solution carries too much concentration risk. To resolve this in our SRI benchmarks, we have introduced an enhanced capping approach in the methodology. This avoids unintended sector deviations as much as possible.'

Melhuish: ‘We have found that one of the real barriers for clients looking at the impact of thematic ETFs is that they don't know where to place it in their asset allocation because there is no natural fit.’

What impact can sustainable ETFs have on companies and industries with less sustainable practices? How can investors drive positive change through sustainable ETFs?

Melhuish: ‘We have launched customised enhanced indices based on research. We rank companies based on our research insights, where the level of engagement is crucial input. This helps decide which companies should be overweight and which underweight. We then try to use our voice and our place at the table as active shareholders to influence our holdings to improve sustainable practices where it is financially material. This is an important way you can have a positive influence through active ETFs.'

Chesworth: ‘You can argue that you are going to sell your stake in a company if that company is not doing what you want. If the company in question does not improve through engagement, you could divest from it, but then it will probably only get worse. So I would say: you are part owner and you keep voting. You stipulate not to leave until things improve and you vote the management team out if it does not comply with your policy.'

Engagement is an important part of achieving net zero because real economic change is needed.

Bialkowski: ‘I think you can have an impact on companies’ sustainability policies even as a passive fund, even if you miss the pressure tool of ‘selling’. With engagement, i.e. engaging with companies and using voting rights, you can certainly influence sustainability decision-making as well.'

Calay: ‘I think about it from the perspective of potentially promoting better corporate behaviour. Encouraging companies to think about their social responsibility can lead to a better world, which is a positive trend. From a portfolio diversification perspective, there is the potential to reduce risk.'

Roggeveen: ‘You can certainly encourage positive change as an investor. Of course, it depends on how sustainable you want to be as an asset owner. In the Paris-aligned benchmark, you exclude certain companies or sectors, e.g. tobacco and controversial weapons, but also the entire energy sector. In the case of the Climate Change benchmark, you still invest a bit in the energy sector, but in the more sustainable companies within it. With such strategies, you allocate capital to a portfolio that also automatically exhibits an increasingly better_carbon footprint over time. Asset managers and asset owners can, or rather should, get involved and vote through engagement and proxy voting programmes.'

Chesworth: ‘The word “reporting” has not yet been mentioned. While it is in a way a curse to have to report on everything, that does not take away from the fact that where you shine the light, things are bound to get better. The fact that you shine a light on companies and ask them to report on things like ESG and their_carbon footprint actually means that improvements will come. Just because there have to be people in the companies thinking about reporting, which has to have some impact anyway.'

 

Philippe Kybourg Philippe Kybourg is Director ETF & Index Fund Analytics at UBS Asset Management, where he has worked since 2018. In his current role, he helps develop innovative and tailored indices for UBS' ETF offerings. Kybourg started his career at index provider STOXX in 2013 and has held various positions there. He holds an MSc in Financial Engineering and Risk Management from the University of Lausanne.

 

Why does engagement remain vital for sustainable investment?

Kybourg: ‘From the companies’ perspective, it is important to understand how certain changes can affect their investment model and also their finances. That is why our engagement programme is twofold: explaining why certain issues are important to us, but also trying to understand how changes can affect companies.'

Is it possible to invest responsibly in government bonds through ESG?

Hoogveld: ‘Our position is that we should consider green bonds issued by European governments as sustainable products. You know these bonds will finance projects that help improve the economy: insulation programmes, clean transport, renewable energy, and so on. As far as we are concerned, this is the right tool for investors who want to have an allocation to a government and do ESG at the same time. A traditional pitfall, of course, is that a portfolio made up of 100% green bonds has a big bias in terms of duration and countries. After all, not all countries in Europe have issued green bonds and usually green bonds have much longer maturities than standard bonds. This makes it difficult for investors to invest in products made up of 100% green bonds because they have no control over country exposure and duration. Of course, there are ways around these pitfalls, and there are ways for investors to use green bonds as a core part of their sustainable portfolios.'

Calay: ‘ESG scores of government bonds are often correlated with a country's level of development, so developed economies like the G-10 score well. Emerging market debt managers argue that strictly ESG-based investing would mean investing only in rich countries, neglecting ESG's goal of promoting sustainable development. Therefore, some EMD managers adjust ESG scores based on income or prioritise ESG momentum over absolute scores. Unlike companies, which are primarily out for profit, government bonds represent governments with diverse motivations, making ESG-driven influencing more complex. The effectiveness of ESG in influencing sovereign bond performance remains debatable.'

Data providers have a lot of influence, as much of the ETF market relies on their ESG ratings of companies.

Bialkowski: ‘It is certainly possible to invest responsibly in government bonds. We have created our own country policy for this. This does have more impact with bonds issued by emerging countries than developed countries. It can be a challenge to find an investment fund that fits such an own policy and excludes countries like Turkey or China, for instance. In that case, we partner with a fund house.'

Roggeveen: ‘For emerging market debt, there are many solutions and there is also a lot of demand from our clients to invest in sustainable bonds from these emerging markets. But investing in sustainable government bonds of developed countries is still a challenge. In Europe, we do see favourable developments, but they are still small steps.'

Kybourg: ‘It depends on the fund's objectives: for example, it is possible to reweight a portfolio based on ESG scores to mitigate certain risks. But that might not be sufficient for a universe with a more uniform ESG rating, such as EU government bonds. In such a case, one way to further integrate ESG considerations is to consider labelled bonds, e.g. green or sustainability bonds.'

To what extent do you think climate change benchmarks, such as the CTB or the PAB, will become strategic for investors, rather than the MSCI World Index?

Roggeveen: ‘This is on the agenda of our clients switching to a sustainable portfolio in line with the Paris climate accords. To what extent then does it make sense to still have an unsustainable benchmark as a reference or should you change your reference and strategic benchmark to a more sustainable benchmark, or even a climate benchmark?'

 

Alexandra Melhuish Alexandra Melhuish works as a Strategist within J.P. Morgan Asset Management's Sustainable Investment Team and is responsible for implementing the sustainable investment strategy in EMEA. Working with the distribution and product teams, she leverages quantitative and fundamental research, AI technology and ESG expertise for sustainable solutions.

 

Chesworth: ‘Climate will be the most important thing for many investors, but will it also be the most important ESG objective? What happens if it would undermine other objectives, for example in the case of geopolitical threats and war, requiring more to be done on social issues. The MSCI PAB indices are a good example where the emphasis is on climate, but where the other ESG factors also play a role. I don't think clients want to cast their vote for one particular component of ESG.'

Hoogveld: ‘It is a difficult question, especially since there are as many CTB or PAB benchmarks as there are index providers. If you make a choice, at some point someone will tell you that this is not the right climate index. There is great complexity.'

Melhuish: ‘We are seeing increasing demand for ETFs based on Paris-aligned benchmarks for clients who want to integrate climate considerations into their portfolios. However, this comes at a time when their methodologies and potential limitations to address climate change on a large scale are also being questioned elsewhere in the market. I think there is still a long way to go before these climate benchmarks will replace standard core benchmarks.'

Hoogveld: ‘It is difficult to choose a climate benchmark as a strategy benchmark. One of the difficulties is that a benchmark almost by definition has to be transparent, and the problem is that climate indices are currently quite complex, which makes it difficult to position them as a strategy benchmark right away.'

Asset managers and asset owners can, or rather should, assert their involvement and voice through engagement and proxy voting programmes.

Kybourg: ‘We see that some investors are actually already making this switch, as they have to align their investment process with their net zero commitments. But there is indeed a lot of complexity regarding which index to select.'

What approaches do different asset managers take to achieving net zero?

Hoogveld: ‘We are part of the Net Zero Asset Manager Association and Alliance and have implemented several actions to achieve net zero. Action in terms of products and services, and in terms of responsibility for us as a company. We want to offer a net zero solution to all our clients, and that they can base such a solution on European equities, on US equities, on euro credit, and so on. We are expanding our climate range to have as many building blocks as possible. This product development and expansion is accompanied by a more assertive engagement policy on the climate issue.'

Melhuish: ‘For us, engagement is the key lever we can use as a long-term active asset manager. This is how we earn our living. We try to use our seat at the table to encourage companies to set science-based targets and support them along the journey to implement these targets.'

Kybourg: ‘We aim to reach net zero by 2050. Towards net zero, we have identified milestones and set clear targets to ensure that our progress can be tracked. In addition, engagement is an important part of achieving net zero because real economic change is needed.'

 

Joris Roggeveen Joris Roggeveen is Executive Director, External Investing Group at Goldman Sachs Asset Management and responsible, among other things, for index strategies. Previously, he was Senior Portfolio Manager at Altis Investment Management, Investment Analyst at ING Investment Office and Investment Advisor at ING Private Bank. He is registered with the DSI as an Investment Analyst and Institutional Portfolio Manager and is a CAIA Charterholder.

 

Are there any particular trends or developments in SRI ETFs? What do you expect for the future of SRI via ETFs?

Roggeveen: ‘We see many clients converting their portfolios, especially on the equity side, from exclusion-based solutions to climate solutions. Their focus is now also shifting from developed to emerging markets and it is also shifting to (corporate) bonds.'

Hoogveld: ‘The most important environmental issue is the climate emergency, then comes the biodiversity emergency. There is a significant increase in requirements related to biodiversity. Investors are increasingly required to look at the impact of their investments on biodiversity and improve biodiversity in their portfolios. It is now an essential pillar of environmental policy.'

Calay: ‘I think advances in regulation and global standardisation will greatly shape the future. And as a data scientist, I'm very excited about improvements in ESG data and methodologies, as they offer the potential to develop more robust products.'

Kybourg: ‘Climate has also become an increasingly important focal point with our clients and in our own organisation. In addition, we indeed see that biodiversity is also increasingly mentioned. We could expect even more solutions in the future that take into account reducing the negative footprint of investments.'

 

CONCLUSION Over the long term, the performance of ESG funds has been good. There are clearly structural shifts underway that are positively affecting the outlook for many companies found in sustainable ETFs. Sustainable funds often have concentration risk. Investors should be aware of such distortions. ESG scores of sovereign bonds are often correlated with the level of development of the issuing countries. There is increasing demand for ETFs based on Paris Aligned benchmarks, but there is still a long way to go before these climate benchmarks will replace standard core benchmarks.

Attachments

• FI-8 - 2023 - RT Sustainable ETFs.pdf