When we talk about socially responsible investing we are referring to an investment approach which incorporates environmental, social, and governance (ESG) factors, in addition to purely financial considerations.
The range of options available to UK investors has never been greater, although the socially responsible ETF landscape is dominated by two fund companies, iShares and UBS. Their offerings span broad regional, single-country and sector-focused funds. One area that remains under-represented is fixed income, with only three ETFs for sale. But understanding the nuances between one fund and the next can be tricky.
Here are three things to consider when selecting an ESG ETF (some low-cost options are listed below).
1. Hard and soft screens
First and foremost, ESG investing can be deeply personal, often revolving around one specific issue, such as carbon footprint or gender parity. So, before investing, it is crucial to understand how an ETF is constructed and whether it meets your own tastes and preferences.
Socially responsible funds often use a combination of hard and soft screens to refine their investment universe. A hard screen may exclude all firms that derive any income from, say, the manufacture of chemical weapons, while a soft screen may exclude only, say, the top 20 per cent of companies with the largest carbon footprint. In the former case, all non-compliant companies could be excluded, while in the latter case, only the biggest offenders would be excluded.
One of the strengths of buying an ETF is its transparency, with fund holdings readily available and open to closer scrutiny.
2. Core or satellite?
Depending on whether you are looking to supplement or replace core portfolio holdings, your choice of fund will differ. For example, the iShares Global Clean Energy ETF, with only 30 holdings, is clearly unsuitable as a core portfolio holding.
Given its narrow and specific exposure limited to companies in the clean energy sector, it should only be used as a satellite holding. On the other hand, the Amundi ETF MSCI World Low Carbon ETF, which is built to match the risk and return characteristics of the MSCI World Index, appears much more appropriate as a core holding strategy.
However, as we know, there is no such thing as a free lunch. When replacing a core portfolio allocation, investors must compromise on ‘purity’ of ESG holdings and consider accepting less compliant holdings, in exchange for retaining the benefits of diversification.
3. Keep an eye on charges
There is a widely held belief that socially responsible investors must sacrifice returns. While, broadly speaking, the academic research on the subject has been inconclusive, much of the short-term underperformance tends to be attributed to structural sector issues and geographic biases observed in ESG funds. For example, some global equity ESG ETF returns have suffered from a persistent underweight to US stocks relative to the broad market over the past five years.
This is because US companies tend to be less ESG-focused than companies in some other regions of the world such as Scandinavia and the eurozone. Common sector tilts in ESG ETFs include underweighting notoriously carbon-heavy energy stocks in favour of greener technology companies. Some funds include sector and geographic constraints to ensure that the characteristics of the fund don’t become too skewed.
One certain way to ensure the best return is to remain conscious of fees. For example, the iShares Dow Jones Global Sustainability Screened ETF’s ongoing charge of 0.6 per cent is significantly more than 0.38 per cent charged by the similar UBS ETF MSCI World SRI ETF.
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