Roundtable Sustainable ETFs

January 30, 2025

_{This report was originally written in Dutch. This is an English translation.}

Sustainable investing is here to stay and should be retained. Sustainable ETF investments will almost certainly increase over time, with dark green being the preferred choice. Impact can be made with passive, broadly diversified ETFs, although for now it is difficult to make the impact concrete for each investment.

By Hans Amesz

Why is the supply of sustainable ETFs still relatively small while demand is growing?

Stefan Kuhn: ‘The sustainable ETF market is still quite young, so it is not surprising that the supply of sustainable ETFs is still relatively small. But with the evolution of ESG and sustainability in Europe, that is changing rapidly. An ETF is, I think, a perfect package to get more investors interested in sustainable investing.'

Camiel van Roosmalen: ‘The supply of sustainable ETFs lags behind the high demand for them because it is difficult even for the demand side to figure out what a sustainable ETF is. The clearer the definitions and regulations become, the more the supply side will want to invest in clearly sustainable ETFs.'

Matthew Tagliani: ‘Over time, you will see that either the percentage of assets in ESG products increases, or the supply of ESG products increases. But it is a slow process, in addition to which the idiosyncrasies of different markets and different types of investors really make a difference. That certainly complicates the growth of the sustainable ETF segment.' Will the current diversification within the ETF range increase in the coming years?

Joep Spoor: ‘There will definitely be more diversification. Many new flavours are entering the market because demand is still changing. For instance, in the last two years we saw the demand shift from dark green to lighter green ETFs, with a focus on reducing tracking error relative to the parent index. Many institutional clients have their own specific area where they want to see their sustainable focus or SDGs reflected. This requires us as managers to deliver new indices.

Guido Hout: ‘Institutional clients ask for a version of ESG, but the demand for the type and colour, such as light green or dark green, varies. More diversification in sustainable funds should be driven from an increasing demand for different sustainability criteria.'

We see the trend of active ETFs arriving in Europe from the US. What does this look like for sustainable ETFs and what can their added value be for an investor?

Jill Rootsaert: ‘If there ís something everyone looks at sooner or later anyway, regardless of whether you are a passive or active investor, it is sustainability. And when it comes to sustainability, we should all be active: actively looking at the benchmark, actively screening companies, assessing the ESG data we get from the data providers, actively looking at what the regulator is doing. From that perspective, I think active sustainable ETFs can do double duty by not only improving alpha potential, but also flexibility in your positioning in changing environments that have a different ESG impact on indices and the underlying companies.'

Effi Bialkowski: ‘We are not currently using active ETFs, but our analysts are exploring this possibility. US active ETFs have tax advantages that do not apply to European active ETFs, which is probably one of the reasons why they are not yet so popular here. Otherwise, we do see the intra-day liquidity and transparency as an advantage for our clients. By the way, we have been using sustainable ETFs for some time, but these follow a sustainable benchmark and therefore we do not characterise them as active ETFs.’

More diversification in sustainable funds should be driven from an increasing demand for different sustainability criteria.

Spoor: ‘This year, we have launched a number of active ETFs, both fixed income and equity. These combine a traditional investment approach with active integration of our proprietary ESG methodology. They are designed for investors seeking a more focused approach to sustainability that can quickly adapt to changing regulations and label criteria, while maintaining a relatively low tracking error. Offering ETFs that combine a recognised ESG approach with high sustainable investment and ambitious decarbonisation targets, while offering the benefits of index-based investing, including reasonable tracking error, will meet the growing demand from institutional clients and distributors to integrate ESG factors into their portfolios.'

Kuhn: ‘Sustainability is a key driver for the existence of active ETFs in Europe - in the US, the tax advantage plays a role. When we talk to clients, they say: we don't really use active ETFs, we want to stay close to the index. However, when those clients look at their portfolios, they see that there are many SRI ETFs in there that are passive, but do add a strong active tilt to the portfolio because, by definition, they deviate from the standard, non-ESG indices. Then it is almost a logical next step to go to an active manager that looks ahead on ESG by identifying companies that are probably not currently considered sustainable, but are on track to become so. For a passive investor looking for sustainability, an active ETF can be a good solution, as you outsource your sustainability duty to a third party you trust.

How do different ETF providers handle their sustainability policies? There seem to be quite a few differences between different providers.

Tagliani: ‘Our promise to ETF investors is to follow a certain benchmark. Investors do not pay us to make subjective decisions, but rather not to do so. Investors want us to adhere to certain standards. All major index providers have ESG methodologies and specific datasets they use. It is very important that investors understand the meaning of an index methodology. What has surprised me is that despite the growth of passive ETFs replicating ESG benchmarks, there are some very fundamental aspects to the construction of an ESG index that are generally not well understood by investors. The simplest example is: if you take the benchmark index and apply the usual standard company exclusions, such as removing tobacco, controversial weapons, or thermal coal, lowering the overall ESG score of your index is usually the first thing that happens then. That's because you remove stocks based on company activities. But the ESG score of the companies in question is often based on how they operate. So a tobacco manufacturer that treats its employees very well will have a high ESG score, even though its business activity might be negative for many ESG-minded investors.'

An ETF is a perfect package to get more investors interested in sustainable investing.

Not long ago, MSCI changed the composition of its sustainable index. How do you deal with that as a provider of passive ETFs?

Kuhn: ‘We do not have passive ETFs that track standard third-party indices. We are not dependent on an index provider changing its sustainability methodology. We start with a non-ESG benchmark and then overlay our own sustainability framework over it.'

Wood: ‘We see fund providers building their own sustainability frameworks. That makes it quite difficult to compare different passive funds properly. Therefore, we encourage investors to look at widely accepted metrics. It would be better if the government or the European Union had created guidelines for this, but regulation lags behind. Therefore, we are inevitably dependent on big data providers like MSCI.'

Bialkowski: ‘Although we use MSCI benchmarks a lot, our own sustainability framework guides us. When MSCI adjusts the benchmarks of the ETFs we use, it is essential that the adjusted benchmark still meets our sustainability preferences. If it does not, we also have the option of working with a fund provider and an index provider to create a new benchmark for a new fund.'

The way ESG is implemented in passive funds is fundamentally different from active ones. Are there aspects of how ESG investing works in a passive context that you think are not well understood by investors?

Tagliani: ‘Investors often assume that providers of passive products have a degree of flexibility that simply isn't there. This is because they are constrained by fund documentation. If you adopt one of the major index providers and feel comfortable with the data they use, you can apply that same data to multiple products from multiple providers. The way index providers have developed their services is that initially it was just about whether we can include ESG at all. Index providers are increasingly starting to incorporate fast exit rules and more frequent data updates into their methodologies. This gives you a response time that is more attractive to investors. There is a gradual evolution. You can do things in terms of turnover management, managing the size of positions relative to benchmarks: apply over- and underweighting. You can manage that intelligently. We find that the biggest surprises generally come from indices that are not that well designed. Intelligent index design can produce more reliable results that are more consistent with the average investor's expectations. It is an ongoing process to evaluate the indices we have, assess their suitability and see if they are still delivering the results we think investors expect. We have a product that tries to replicate the broad European government bond market and tries to incorporate ESG as much as possible through the use of green bonds. That is difficult to include in an index methodology because green bond markets are complicated. The application of ESG in the fund is active because subjective decisions are made. But it is not active from the perspective of seeking alpha, it is active from the perspective of incorporating ESG.'

Rootsaert: ‘Communication is everything. I think we have all experienced a situation where active became passive and vice versa. So you will be able to find active ETFs within Europe that are active from ESG or active from alpha potential or both. That will vary from house to house. As the market leader, we see the most success in our research-enhanced index ETFs and there the active ESG overlay appears to be as important as the alpha target. It's a and/or story, depending on the investor.'

Often more sustainable ETFs are slightly more expensive because they require more research, reporting and communication, leading to an additional layer of costs.

How are shareholder meeting votes and engagement handled within an ETF? Is this group policy or specific to the ETF?

Spoor: ‘When we receive a request for proposal, an RFP, for an active fund strategy, there are many questions about voting and engagement, but when we receive an RFP for a passive mandate or a passive ETF, there are significantly fewer questions about this. Our sustainability centre provides engagement and voting at shareholder meetings. It regularly happens that at shareholder meetings, proposals are put forward by company management that we do not agree with, for example on remuneration or dealing with sustainability and energy transition. Voting and engagement are really a way of looking ahead and getting companies to do something in the future. If you have to select a particular index manager, you obviously have to take into account how such a manager conducts engagement and voting. There is a report every year on how voting has gone and how our engagement has been. That is really transparent and we can share this reporting with our clients. The necessary information is there and getting better every year.'

Wood: ‘Voting and engagement are essential for us. Within passive mandates, voting and engagement are appropriate to make an impact. Something that sometimes scares us is that sustainable funds use securities lending and therefore do not own a relevant stock to use it to vote ‘green’. So for our sustainable index investors, we mainly do not use funds that do securities lending, unless standard provider policy dictates that shares are ‘recalled’ in order to do vote. And within that context, we see a big difference between different ETF providers: European providers generally vote greener than US ones. This is because in the US the focus is much less on ESG than in Europe, where there is actually a trend towards more ESG. That has to be taken into account.'

Over time, technological advances, increased competition, the growing scale of ESG investments and clearer regulations will all contribute to lower costs.

Kuhn: ‘We make no distinction whether we have a company in an ETF or in an active mutual fund. This applies to engagement and voting as well as information gathering. We have a global team of about four hundred investment professionals who last year had about twenty thousand meetings with companies we invest in. We use all that information to create our fundamental and sustainable ratings and to decide how to vote. Communication and education are important for investors to understand what they want: purely the index or more opportunities to implement issues around the index. In the latter case, an active ETF is the better solution.'

Rootsaert: ‘In voting and engagement, analysts are crucial. They are the ones who, usually over a long period of time, have spoken or are still speaking to the various board members: CIOs, CFOs, heads of sustainability policy. Analysts in Asia, the US, China, Europe all need to use the same common language when it comes to ESG and engage. The presence in such meetings of sustainable investment stewards and continuous feedback between portfolio managers, analysts and stewards is crucial for impact. Of course, it is up to investors to decide whether they prefer the sustainable investment vehicle or the unsustainable one and its variations. ESG is, I think, the one area where everyone is right and everyone is wrong. We have clients who have switched from passive SRI to active SRI, for example, but we also still have clients who are passive unsustainable investors who want to switch to our active SRI policy, but more from alpha potential than from sustainability. All the knowledge gathered by analysts is shared with the investor and that very communication is very important to provide insight into our voting behaviour and engagement.'

Why are sustainable ETFs more expensive than non-sustainable ones?

Bialkowski: ‘Often more sustainable ETFs are slightly more expensive because they require more research, reporting and communication, which leads to an extra layer of costs. If we want to invest more in sustainable ETFs, these costs need to be addressed. This should be possible, for example through economies of scale.'

Van Roosmalen: ‘If investors choose a more sustainable ETF, they are generally willing to pay a bit more for it. As ESG data becomes standardised and more accessible, costs can come down. Now, there is often a need to create your own framework or choices. When there is clarity, costs can come down. Over time, technological advances, greater competition, the growing scale of ESG investments and clearer regulations could also contribute to lower costs.'

Kuhn: ‘We believe that our clients are willing to pay around 15 to maybe 20 basis points on top of the price for pure beta - which has fallen in recent years - to access our sustainable active expertise. Most clients look at output, at what they want to get out of the fund. This is related to sustainability to the extent that some five years ago it was widely seen as a generator of alpha: sustainable companies will outperform unsustainable ones in the long run. The price pressure on the pure passive sustainable angle is higher than on the combination of active and sustainable.'

Wood: ‘I don't know if more competition will bring costs down. In the sustainable world index funds we use, costs are relatively low, of course also because of their size. In the Netherlands, we can also use the FGR fund structure for our investors, the structure of a Common Account Fund, which means we are optimised for dividend tax leakage. If we balance the tens of basis points we gain from optimisation for dividend tax, slightly higher costs of an FGR are not an issue.'

How do investors use sustainable ETFs in their portfolios?

Bialkowski: ‘In our asset management portfolios, we use ETFs with different levels of sustainability. In our most sustainable asset management portfolio, you will of course also find the most sustainable ETFs. These are more concentrated than the less sustainable ETFs due to the exclusions applied. In addition, in the most sustainable portfolio we do not invest in all asset classes: gold is an example of this.'

Van Roosmalen: ‘We look at what clients want and provide tailor-made solutions. If they want dark green, they get that. Other options are also possible. We are not going to force dark green on a light green customer or vice versa. In general, I think as an asset manager, you have to listen to the client, whether it is sustainability, cost, or other issues. Hopefully everything will be sustainable in the long run.'

There are many grey areas with regard to sustainability and nothing is as simple and black or white as we might like.

Kuhn: ‘I think you can build more fine-grained portfolios if you combine sustainable and non-sustainable ETFs. So I would say our clients' non-sustainable solutions include sustainable ETFs if they fit the asset allocation. But there is a higher proportion of non-sustainable ETFs, simply because they offer more choice to build your portfolio.'

Rail: ‘We mainly offer sustainable ETFs, so we don't see flows of non-sustainable ETFs. We offer ESG ETFs with low tracking error and Paris-Aligned Benchmarks ETFs, it's purely what the customer wants. If they have a dark-green investment philosophy, they will often choose our Paris-Aligned Benchmarks ETFs. If they are looking for an ESG ETF with low tracking error, they will choose our ESG Filtered Min Tracking Error ETFs. If they are looking for an ESG approach with high sustainability investments and ambitious decarbonisation targets, they will end up with our sustainable active ETFs. In the Netherlands, just about all asset owners have an ESG mindset and will therefore invest in an ESG ETF.'

Given the increasing regulatory focus on defining sustainability standards, how can investors support current ‘green’ companies without neglecting opportunities to allocate capital to ‘grey’ companies ready to invest in and develop more sustainable business practices?

Wood: ‘If capital flows to more green companies, it becomes more attractive to invest in sustainability. But we also need to ensure that companies that are ready to adapt have access to capital to actually enable that adaptation to more sustainable operations. If we engage with companies that show serious willingness to take a step further towards the green market and actively communicate with these parties, we can make sustainable impact even with passive investments.

Rootsaert: ‘The question is how to measure that companies are making the right efforts to become more sustainable. What data from which data suppliers do you use? There are nuance differences and the world of data suppliers is constantly changing. When you start a conversation about portfolios in transition towards greater sustainability, you have to realise that it can never just be black or white, but that it will also sometimes not be easily quantifiable. There is a need for verification by a third party who is not an index provider and who looks at it a bit more holistically.'

Tagliani: ‘There are many grey areas with regard to sustainability and nothing is as simple and black or white as we might like. That has made the dialogue in the market around ESG considerably more difficult than it should have been. I think this ultimately hinders the greater growth of investment in companies that should benefit from it because they are in fact heading in the right direction.'

How can transparency and standardisation in the criteria for sustainable ETFs be improved to help investors make more informed decisions?

Kuhn: ‘There is certainly a solution to that, but I struggle to see it in the short term. Take nuclear power, one of the standard examples used to reflect the different thoughts on it in Europe. Is nuclear power green, grey, brown? Is it right or wrong? There are, I think, certain things on which there is broad agreement, for example tobacco or controversial weapons. Those don't actually need regulation, but many other topics do. Finding a solution for everything is difficult and complicated, because I think sustainability is tailor-made, something personal. Hopefully I am wrong, because a one-size-fits-all solution would make our lives a lot easier. Maybe in a few months, quarters, years, or whatever time frame, we can have a standard solution, but at the moment I don't see that happening anytime soon. The issues are too complex for that.'

Sometime in the next 10 years, a market will emerge that will solve all the current questions and problems surrounding SRI.

Bialkowski: ‘As an organisation, we regularly communicate to our clients about the sustainability profile of the investment portfolio. I do see a difference here between institutional and retail clients. This is because there is a lot of information available, but it is often very complex for a retail client. It is a challenge to inform a retail client about the sustainability of his investments in understandable language. Retail customers often find it difficult to read pages of investment content, so information needs to be provided in a compact and understandable way. Artificial Intelligence (AI) can, I think, make sustainability communication more understandable.'

Rootsaert: ‘In the short term, open communication will be important. In terms of selection, we often see that a screening of a strategy either comes under an active or a passive team, while both teams can learn so much from each other. In addition, you often have separate ESG teams, which look at blacklists, exclusion lists et cetera with an eye on their own house policies. We need critical thinking with an open mind more than ever to achieve a common goal: to ensure that portfolio managers have enough tools to build a healthy, well-diversified, sustainable portfolio and be able to use their years of experience and knowledge to do so, rather than all the internal checklists. In the Meantime, it is up to us asset managers to also share all information with our clients as openly as possible, understanding the nuances in different countries. I am convinced that in the long run, there will be a data vendor that will stand out from everything that is currently available, whether it is AI and/or bringing together the different data carts. Sometime in the next decade, a market will emerge that will solve all the current questions and issues around SRI.'

Rail: ‘Of course, it also has to do with the companies we invest in. They have to provide us with standard metrics, information about what they are doing at company level. That will make it easier for us to determine which companies are best to invest in with a sustainable focus. It will take a few years to get that done, though.'

Is there anything else you guys want to say?

Wood: ‘We help clients meet their desired ESG targets with their funds. With passive, broadly diversified ETFs, I think it is difficult to make the impact concrete per investment. It would be nice if that changes in the future, for instance through better data quality, so that you can see concretely what the impact of a sustainable ETF is. I hope we can achieve that as an industry at the end.'

Rail: ‘Firstly, I think SRI is something that is here to stay and is also worth preserving. I am sure dark green ETF investments will increase over time. Investing in active sustainable ETFs, in my opinion, is a way to add more than just following a particular index. Active ETFs allow you to select asset managers that are truly sustainable.'

Kuhn: ‘I think as an industry we can be more aggressive in promoting sustainability because it goes beyond exclusions. Impact and ETFs are difficult to combine because the rules are actually too strict, but we can influence with engagement and help companies on the road to sustainability.'