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Defining the universe of sustainable ETFs and index funds

Alex Bryan  |  03 Sep 2020Text size  Decrease  Increase  |  
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As part of our Passive Sustainable Funds: The Global Landscape 2020, we have defined the universe of passive sustainable funds.

These include index funds and exchange-traded funds globally that:

  • use ESG criteria as a key part of their selection or weighting process; and/or
  • indicate that they pursue a sustainability-related theme; and/or
  • seek a measurable positive impact alongside financial return.

A broad range of approaches

The universe of passively managed sustainable funds represents a broad range of approaches that aim to address a variety of sustainability and investment objectives.
Passive approaches vary on where they draw the line on ESG performance and on how closely they structure the portfolio to a standard benchmark.

Some portfolios provide broad market exposure and hold hundreds of securities, while others focus more narrowly on specific sustainable subsectors like renewable energy and can hold as few as 20 stocks.

To help navigate the cluttered landscape, we have subdivided the sustainable passive universe into smaller groupings.

ESG exclusions-only funds

The first group are those sustainable passive funds that apply ESG-only exclusionary screens to broad indexes. Commonly, these filters will screen-out companies that have breached United Nations Global Compact principles. Other common exclusions target companies associated with thermal coal and oil sands extraction or tobacco.

An example is the largest passive sustainable fund globally, the US-domiciled Vanguard FTSE Social Index VFTNX. Beginning with a standard market cap US large- and mid-cap equity index, the fund excludes companies in the following industries: adult entertainment, alcohol, tobacco, weapons, fossil fuels, gambling, and nuclear power. It also excludes stocks that violate UN Global Compact principles.

The ESG Exclusions-Only approach tends to screen out only a fraction of the underlying universe, meaning that the strategy retains the core characteristics of the parent index. In some cases, after the screening process, fund holdings are reweighted using an optimiser to further reduce tracking error versus a parent index. This means most are suitable as lightly ESG-flavoured replacements for core portfolio allocations.

Broad ESG funds

Broad ESG funds go beyond exclusionary screens and select and/or weight holdings from an underlying universe based on an ESG scoring system. This approach allows a fund much more flexibility to prioritise those securities with the best ESG scores relative to their respective region or sector. It can also allow companies that show an improving ESG profile to be rewarded. In most cases, this results in a purer ESG exposure than is available with an Exclusions-Only approach.

The Broad ESG approach encapsulates a wide variety of strategies that range from best-in-class, which invest only in the highest ESG scorers, to those that reweight the holdings in an existing index based on ESG metrics.

The largest sustainable ETF in Europe, the iShares MSCI USA SRI ETF SUAS, which has a Morningstar Analyst Rating of Bronze, is an example of the former. It invests in the most ESG-compliant quartile of the free-float adjusted market capitalisation of the US equity market by sector. It also avoids fossil-fuel extractors and producers, in addition to standard MSCI Business Involvement Screening. Despite excluding more than three fourths of the parent index, the sector-neutral approach ensures that the fund largely retains its parent’s core characteristics

Different passive approaches to ESG investing

esg1

Source: Morningstar Research

Sustainable thematic funds

Sustainable Thematic funds select holdings based on their exposure to one or more sustainable themes. These funds can be further subdivided into two distinct groups.

Broad Thematic funds aim to provide broad market exposure while advancing the given theme. These funds tend to be well-diversified and may be suitable as replacements for core portfolio holdings.

For example, the US-domiciled SPDR SSGA Gender Diversity ETF SHE aims to tackle gender inequality by investing in approximately 175 companies with the best gender-diversity credentials among their leadership ranks in each sector and seeks to minimize differences in sector weights versus the broad market.

As their name suggests, Narrow Thematic funds pick a more focused group of investments with the intention of pursuing a sustainable goal. The relatively few holdings are often clustered into one or two sectors and can resemble alternative sector funds. This highly concentrated exposure means these funds are best deployed as a satellite holding within an already diversified portfolio.

For example, the Invesco Solar ETF TAN selects fewer than 25 stocks in the solar energy industry and has over 80 per cent of fund exposure to stocks in information technology and utilities.

Broad vs narrow thematic

esgfund2

Source: Morningstar Research

is director of passive strategies research, North America, for Morningstar.

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