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What if I want to buy an ethical ETF? Pt 2 – International equities

Lewis Jackson  |  09 Feb 2022Text size  Decrease  Increase  |  
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Editor's Note: This is part two in our series on picking sustainable ETFs for your portfolio focusing on international equity ETFs. View part one on domestic equity ETFs here.

So, you’ve picked an ethical exchange traded fund (ETF) filled with Australian stocks. What’s next? International equities are a vital diversifier given Australia makes up just 2% of the global share markets by market capitalisation.

International equity ETFs pose the same questions for sustainable investors as their local equivalents: How do funds and index providers put words like “sustainable”, “ethical”, or “responsible” into practice with their stock selection? What companies do they hold and reject? Are there risks on the path to sustainability? Is performance strong and are fees reasonable?

To help investors answer these questions, Morningstar has pulled out the three largest international equity ETFs which consider environmental, social and governance (ESG) listed locally for a closer look.

Under the microscope are:

  • BetaShares Global Sustainability Leaders (ASX: ETHI), largest of the three at $2.3 billion in size and rated 'Bronze' by Morningstar analysts.
  • Vanguard’s Ethically Conscious International Shares (ASX: VESG), the overseas equivalent of its popular domestic equity ESG fund.
  • iShares Core MSCI World Ex Australia ESG Leaders ETF (ASX: IWLD), rated 'Gold' by Morningstar analysts.

Note, all are broad-market funds and hold hundreds of stocks drawn from across the developed world. Those looking for funds investing solely in clean energy or other sustainable themes can read our review of local options funds here.

Sustainable stock picking

The three funds sit on a spectrum based on how strictly they penalise companies with low environmental, social and governance (ESG) scores while promoting those that score highly.

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“Shades of green” is how Paul Garner describes the ESG fund universe. He is a financial adviser at Novo Wealth and member of the Ethical Advisers Co-op.

“There are shades of green. We don’t, as part of the Co-op, think that the Vanguard and iShares funds are particularly green. But it’s about the individual person and what they’re comfortable with.”

The index tracked by ETHI takes the strictest approach, putting its developed world stocks through two major sustainability filters to pick out the 200 “Climate Leaders” in the portfolio.

First, companies with low emissions relative to revenue are prioritised, as are those meaningfully involved in emissions reduction. Then, a series of screens remove those involved in fossil fuels, 'sin' industries such as gambling and alcohol, and other controversial sectors.

As with the domestic BetaShares Australian Sustainability Leaders ETF (ASX: FAIR), final decisions are made by a committee of three, made up of BetaShares representatives and an external member.

At iShares, ESG scores from index provider and research firm MSCI are used to sort the 700 odd company portfolio. They pick out the top scoring ESG performers in each sector after filtering out controversial industries such as fossil fuels and weapons, and companies who score poorly on ESG rankings.

Note, ESG scores generally measure the risk of material value destruction. They are not indicators of whether a company operates in an explicitly sustainable industry. For example, BP is rated as a high ESG risk by Sustainalytics, while French oil and gas producer TotalEnergy is scored a medium due to strong management of ESG issues.

Of the three, VESG employs the simplest approach. Negative screens remove companies with significant business activities in non-renewable energy, sin and weapons. The cull leaves approximately 1564 stocks from the 2000 odd in the parent index. The absent include Facebook owner Meta Platforms.

Fossil fuels? Mostly no

The BetaShares fund scores highest on a range of Morningstar sustainability metrics which measure ESG risk across the portfolio.

A quarter of ETHI’s holdings have an ESG risk scores of “medium” or higher, compared to 40% and 49% for IWLD and VESG, respectively.

The Vanguard and iShares ETFs have small exposures to fossil fuels via companies involved in natural gas processing and transportation. VESG holds a small stake in US utility Alliant Energy Corp, while IWLD owns natural gas pipeline operators and processors, such as Cheniere, Williams Company and ENEOS Holdings.

Firms may have passed screens because they are not directly involved in oil and gas drilling, or revenues fell below a certain threshold.

Emissions heavy industries are also in the portfolio, for example the world’s second largest cement maker, HeidelbergCement.

ETHI has zero fossil fuel involvement according to Morningstar data.

When it comes to renewable energy companies, both VESG and IWLD contain a greater number than ETHI, in part thanks to larger portfolios . All three share Vestas, the Danish wind farm manufacturer. VESG and IWLD also have European renewable energy operators EDP Renovaveis and Verbund in addition to New Zealand’s clean energy utilities Meridian and Mercury.

Lots of tech, not so many FAANGs

Removing chunks of the utilities, energy, industrial and mining sectors skews our international ESG portfolios towards larger companies across a fewer number of sectors.

The tilt is most notable in technology stocks, which take up a third of ETHI and a quarter of the other two funds, compared to a fifth for the which category average. All three funds have a bias towards North America, as do most broad international equity index funds, given the size of US markets. This ranges from 70% of the portfolio in VESG to 75% in IWLD.

Technology looks different across the three funds. Of the FAANGs—Facebook (now Meta), Amazon, Apple, Netflix and Google (Alphabet)—ETHI holds just Apple. IWLD cuts Meta Platforms and Amazon while VESG holds all five.

ETHI opts instead for big holdings in chipmakers and software companies such as Adobe. A tenth of the fund is split between Nvidia and Dutch semiconductor equipment manufacturer ASML. Bigger stakes partly reflect the smaller number of holdings. With 200 stocks, each is weighted more heavily.

Concentration across a narrower set of sectors varies between the funds. Technology, financial services, healthcare and consumer cyclical make up 85% of ETHI, versus two thirds at iShares and Vanguard.

VESG and IWLD are closer to the broad-market index, accepting higher technology for slightly less exposure to mining, industrials and energy.

Tracking closely to the broader non-ESG index is explicit in the Vanguard and iShares’ approach. IWLD has processes to limit the “systematic risk introduced by the ESG selection process” while Vanguard’s marketing materials says investors “don’t need to compromise their portfolios by taking significant moves from the broad market return".

Choosing a fund that deviates from the broad-market index means performance will vary too, sometimes outperforming, sometimes underperforming. Outperformance is easy to stomach but investors also need to ask whether values are solace enough if their portfolios languish while others boom, says Garner.

“What’s more important to you? Is it values? That I’m going to sleep at night knowing I’m not supporting fossil fuel companies,” he says.

“Or am I going to lose sleep because resources are going nuts, and my portfolio is underperforming?”

Bull market buoys performance

International ESG investors have not had to worry about underperformance in recent years, as a falling interest rates, roaring bull market and strong showings for technology and growth stocks boosted portfolios.

Over the past three years, ETHI returned an annualised 27% annualised, versus 19% for VESG and IWLD.

IWLD topped the list in 2021, raking in 33%, versus mid-twenties returns at the other two funds.

Outperformance among technology stocks has helped ETHI in the years since it was founded, says Morningstar manager research analyst Zunjar Sanzgiri.

“ETHI is behaves quite differently to the MSCI World Index owing to significant sector skews... These differences have worked in favour of the fund since its inception in 2017, mainly due to an overweight in tech stocks.”

All three funds outperformed the broader MSCI World ex-Australia during the January selloff, declining between 3.4% and 4% compared to 5.2% for the benchmark index. ETHI, in particular, was shielded from the double-digit declines in Netflix.

BetaShares’ fund charges the highest fees with management fees and expenses of 0.59%, compared to 0.17% for VETH and 0.09% for IWLD.

Making the right choice for you

Many ETF investors are attracted by the simplicity, diversification and low cost of index tracking funds. By definition, ESG-conscious investors differentiate themselves from broad market indices by cutting exposure to oil drillers, weapons manufacturers and others.

The ESG-conscious investor needs to ask themselves how far they are willing to stray from the performance of the broad market index in pursuit of their values, says Paul Garner.

“It’s about explaining the difference between following the index and not. Sometimes you’ll beat it and sometimes you won’t,” he says.

Investors looking for stricter screens and comfortable with deviation have multi-asset options such as the BetaShares Diversified Balance ETF (ASX: DGGF), he notes. The product combines ETHI with the manager’s sustainable Australian equity and bond funds (ASX: GBND).

For those who want responsible international investing within sight of the broad market, IWLD is an “excellent choice”, says Morningstar analyst Sanzgiri.

“The ESG orientation does not meaningfully affect its ability to mimic a diversified global index,” he says.

is a reporter and data journalist with Morningstar. Tweet him @lewjackk or get in touch via email

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