A new breed of ETFs exclude ‘sin’ stocks without seeking saints

A new breed of ESG ETFs just uses negative screens to exclude ‘bad’ companies, rather than targeting those with positive ESG characterisitcs.

Sustainable investing is gaining traction among retail investors, and not just with millennials and women. People of all ages and genders are looking to increase their investment in companies with good environmental, social and governance (ESG) standards.

To respond to this growing demand, the pace of product development in Europe has been accelerating. It reached a record high in 2018 with the launch of close to 300 new ESG funds, including 36 ETFs. Already, there are 56 sustainable ETFs listed on the London Stock Exchange, spanning a broad range of approaches that address various sustainability and investment objectives

Table 1: Distribution of Morningstar ESG ratings for London-listed ETFs

Morningstar Sustainability Rating   ESG ETFs   Full fund universe
High 63% 10%
Above Average 20% 22.5%
Average 17% 35%
Below Average 0% 22.5%
Low 0% 10%

Source: Morningstar Direct, as at 4 February 2019

Best-in-class approach

As one would expect, most of these funds score highly on environment, sustainability and governance (ESG) factors because most use a best-in-class approach, tilting towards companies with better sustainability profiles and underweighting or excluding companies with poor sustainability profiles.

Most sustainable ETFs therefore also have a high Morningstar Sustainability rating of four or five globes, signalling that they fare better than their global category peers (see Table 1).

Unsurprisingly, the ETFs with the highest sustainability scores are those that employ the strictest approach to ESG screening. This is the case, for example, with ETFs tracking either MSCI SRI or MSCI ESG Leaders indices. These include the highest-scoring 25% and 50% of companies within each sector, respectively.

However, seven of the 12 ESG-screened ETFs launched by iShares and L&G last year (see Table 2) have received only an average sustainability rating of three globes.

The reason for this outcome is simple. The new funds do not explicitly target companies with positive ESG characteristics. They merely use negative screens to exclude companies based on their products or practices. iShares’ suite of ESG-screened ETFs excludes companies involved in controversial activities such as arms, tobacco, thermal coal and controversial weapons production, as well as companies in violation of any of the 10 principles of the United Nations Global Compact, which cover corruption, the environment, human rights and labour. L&G’s ETFs, which in fact aren’t even labelled ESG, exclude only pure coal miners, producers of controversial weapons and companies violating the Global Compact principles.

These are relatively light screens and result in only a small number of stocks being excluded from the parent index, from 12 for the iShares MSCI Japan ESG Screened ETF to 122 for its emerging markets equivalent (note that the MSCI EM IMI parent index has 2,881 holdings in total).

Performance deviation from the parent benchmark will vary from fund to fund but is expected to remain low, with tracking error across the iShares ESG-screened ETF exposures ranging between 0.49% and 0.60% (compared with a tracking error of 1.1-4.7% for MSCI SRI and ESG Leaders indices).

The only exception is iShares MSCI Europe ESG Screened ETF, whose tracking error goes up to 0.84%. This is to be expected. By shunning big names like Shell, British American Tobacco, Novartis and Bayer, the fund removes a 13.6% weighting of the parent index. This compares with weightings of 3.5% and 5.7% respectively for Japan and emerging markets. Yet despite the magnitude of the exclusions, the fund only gets an average rating of three globes.

Table 2: ESG-screened ETFs launched by iShares and L&G in 2018

Name Morningstar Sustainability Rating TM Ongoing charge (%)
L&G UK Equity ETF Average 0.05
L&G Europe ex UK Equity ETF Average 0.1
iShares MSCI EMU ESG Scrn ETF EUR Acc Above Average 0.12
iShares MSCI Europe ESG Scrn ETF EUR Acc Average 0.12
iShares MSCI EM IMI ESG Scrn ETF USD Acc Average 0.18
iShares MSCI World ESG Scrn ETF USD Acc Average 0.2
L&G Global Equity ETF Average 0.1
iShares MSCI USA ESG Scrn ETF USD Acc Above Average 0.07
L&G US Equity ETF Average 0.05
iShares MSCI Japan ESG Scrn ETF USD Acc Above Average 0.2
L&G Japan Equity ETF Above Average 0.1
L&G Asia Pacific ex Japan Equity ETF High 0.1

Source: Morningstar Direct, as at 4 February 2019

Ultra-competitive pricing

ESG-conscious investors may wonder about the merits of investing in any of these new average-rated ESG-screened ETFs. This is a fair question. Perhaps the most attractive feature of these funds is their ultra-competitive price. The iShares and L&G ESG-screened ETF ranges charge fees between 0.05% and 0.2%, which makes them cheaper than most non-screened rivals.

However, investors who would rather hold a more comprehensive ESG portfolio that leans toward companies with better sustainability profiles will have to pay a little bit more and select ETFs that track SRI and ESG Leaders-type indices.

Hortense Bioy is director of passive strategies and sustainability research, Europe, at Morningstar.

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