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Sharemarket decline highlights risks in sustainable ETFs: Editor's Note

Emma Rapaport  |  22 Jan 2022Text size  Decrease  Increase  |  
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The technology-heavy Nasdaq entered a correction this week, finishing Wednesday 10.5% below its all-time closing high recorded last November. Analysts are pegging the decline to growing expectations the US Federal Reserve will take a more aggressive stand in raising interest rates this year to prevent spiralling inflation. This action tends to disproportionately hurt the shares of high-growth companies because investors value them based on earnings expected years into the future.

Exchange-traded funds (ETFs) tracking the performance of smaller and specialised slices of the global technology sector have been caught up in the decline, but so too have broad global equity funds which consider environmental, social and governance (ESG) factors. BetaShares Global Sustainability Leaders ETF – Currency Hedged, iShares Core MSCI World ex Australia ESG Leaders (AUD Hedged) ETF and Vanguard Ethically Conscious International Shares ETF have all underperformed the MSCI World benchmark since mid-November, returning -4.5%, -4.15% and -3.6% respectively. Why? As my colleague Lauren Solberg wrote this week, the very reason why sustainable strategies outperformed in 2021 is the same reason they're underperforming now: a bias towards large tech and growth stocks.

"When environmental, social and governance (ESG) funds exclude less-sustainable companies, they tend to pile up positions in mega-caps that earn better ESG metrics," says Morningstar analyst Lan Anh Tran. This means that they have a disproportionately higher representation than the conventional index.

“Companies like Microsoft and Tesla that pass ESG screens end up carrying nearly 2 times their broader market weight," she says. "That has implications on performance. In 2021, those weights worked in favour of ESG strategies. Nvidia, a mega-cap tech company that returned over 125% in 2021, has a 3 times greater weight in the Morningstar US Sustainability Leaders Index than in the broader market."

Tran adds the strictness and manner of the screening can also have an impact on sectoral biases. For example, the BetaShares Global Sustainability Leaders ETF and VanEck MSCI International Sustainable Equity ETF both employ both positive and negative screens to find ESG leaders and exclude companies with exposure to activities like fossil fuels and tobacco. But one has a 32% portfolio weight in the technology sector while the other has just 4%. Some funds may choose to exclude companies like Meta Platforms (FB) or Amazon.com (AMZN) due to privacy or labour rights issues, others don't. It all depends on their approach to ESG.

“Simple ESG screening strategies are always going to look similar to the broader market, but stricter screens can result in stark differences," she says.

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As the tech sector decline weighs, so too does an underweight exposure to value segments of the market – notably energy. ESG screens often avoid the energy sector, an area of the market filled with oil and gas companies. Top-performing global equity ETFs since mid-November include the VanEck MSCI Value ETF (+7%) and the ETS S&P 500 High Yield Low Volatility ETF (+7%) and the BetaShares Global Income Leaders ETF (+6%) – all funds which have benefited in the rotation to value stocks.

Sectors rise and fall with market cycles. Trying to time the market and predict interest rate changes is a fool's errand. If you prefer ESG-friendly strategies, that's great. Those investments have delivered competitive long-term returns. However, it's important to understand the added risk you're taking when deferring from the broad index. Excluding companies or sectors from an index and focusing on ESG-leaders can add concentration risk, sectoral biases and volatility. Single stock and sector exposure limits employed by some sustainable ETFs reduce the amount of divergence between the ESG index and the benchmark, but the differences are there, working in favour of the funds during certain market conditions, but not all. The rough start to the year may be short-lived, and falls so far have been modest in light of recent outperformance. But continued rotation from growth to value stocks as central banks gear up for meaningful changes to monetary policy could spell trouble for funds with big tech exposure. As my colleague Graham Hand noted this week the important thing is you understand what you're buying.

Referring to BHP's increasing dominance in the S&P/ASX 200 Index he writes:

"As the Australian stockmarket becomes more concentrated in a few big names, and as ETF issuers move away from liquid markets into specialised sectors, it is increasingly necessary to check what is in an index. The word 'index' does not refer only to broadly-based market indexes, as there are thousands of them (Morningstar alone has 1,330 indexes). Investors should not simply buy an index fund and assume it is diversified."

For a deep dive on ESG ETFs trading on the ASX, Morningstar data journalist Lewis Jackson has published the first in a three-part series looking at this sector. Part one looks at Australian equity ESG ETFs. Parts two and three will explore global equity ESG ETFs and global bond ESG ETFs. 

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This week, Morningstar global equity analysts published their annual list of the best companies for investors to own. These are a group of rock-solid companies that analysts believe are truly positioned to stand the test of time. They aren't advocating that you buy shares of every company on this list today. Even the greatest company can be a bad investment if you overpay. Still, they believe these companies are essential for any stock investor’s watchlist.

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is the editorial manager for Morningstar Australia. Connect with Emma on Twitter @rap_reports. You can email Morningstar's editorial team editorialAU[at]morningstar[dot]com

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