ETFs Offering Tailored Approach to Low Carbon Investing

As climate risks predominate, institutional investors are increasingly looking at ETF  asset allocation, both traditional and bespoke, to limit exposure to carbon-intensive holdings.

The pandemic has been a positive experience for purveyors of ESG-focused exchange-traded funds (ETFs). According to recent Bloomberg Intelligence figures, ESG ETF inflows hit US$75 billion in the first half of 2021, well on track to surpass a projected US$115 billion for the whole of the year.

Adeline Diab, Head of ESG and Thematic Investing EMEA & APAC at Bloomberg, says the surge was driven both by ‘’the pandemic and the global race to net zero carbon emissions putting ESG criteria into orbit”.

Bloomberg Intelligence believes the trend will keep growing at a rate of 35% per year, with US$1 trillion invested in ESG ETFs by 2025.

“Institutional investors are already significant investors in ETFs, and they are becoming bigger,” says Matt Tagliani, Head of EMEA ETF Product and Sales Strategy at Invesco. “It is part of every conversation I have.”

One institutional investor with a clear ESG ETF strategy is Finland’s Varma Mutual Pension Insurance Company. In 2019, it set a target that 35% of the ETFs it was invested in would be low carbon by 2025.

“We have a stated aim to be carbon neutral by 2035,” says Hanna Kaskela, Director, Responsible Investment at Varma. “ETFs should be in line with our climate policy which should not invest in companies that violate global norms like the UN Global Compact. In 2019 it was difficult to find such ETFs but now the market has changed, and we have already achieved the 35% target. More investors are demanding ESG solutions and so the supply of such ETFs has increased.”

Forward-Looking Data

Kaskela says it is easier to find low carbon holdings in ETFs because companies are producing more forward-looking data such as emission reduction targets.

“ESG data used to be a bit too much backward looking,” she says. “Now, it is getting more aligned with traditional investment data.”

Considered basic by some, Tagliani is positive about the growth of passive ESG ETFs.

“Before we speak to institutional investors, they already have their own views on the ESG criteria which really matters to them,” he says. “They then look across the range of products available and find those that align well with their standards. Some exclude certain sectors such as thermal coal or align with the Paris agreement. The great advantage of passive ETFs is that the index methodology can’t be changed. Generally, there will be a product which meets their needs.”

Helping in that aim, but offering a little more flexibility, is the growth of thematic ETFs, argues Mark Fitzgerald, Head of Product Specialism at Vanguard.

“Such ETFs only contain around 30 stocks so act very much like active funds,” he explains. “There are so many ways to peel back the onion through thematic ETFs, for example avoiding fossil fuel extraction in the run up to COP26 or sub-sets of indices looking at other ESG sectors.”

Another option in ESG is smart-passive ETFs which track an index but allow for more active stock-picking. An example is the newly launched AUAG ESG Gold Mining ETF which holds 25 best-in-class ESG risk rated gold miners such as those using on-site solar farms.

“This is the first ETF to use active ESG within a sector,” says AUAG Funds Chief Executive Eric Strand. “Promoting positive ESG changes in an industrial sector will have a larger net-effect for the world compared to other sectors.”

The pure active ESG ETF market is also helping investors reduce carbon risks. One example is Varma’s recent €200 million investment in the BlackRock US Carbon Transition Readiness ETF which listed on the New York Stock Exchange on 8 April. It invests in US firms lowering carbon emissions as well as focusing on other sustainability criteria related to the environment.

The ETF overweights companies that are believed to be better positioned to benefit from the transition to a low carbon economy and underweights companies that are poorly positioned. The criteria include fossil fuels and clean technology.

Bespoke ETFs

Varma has also looked for more bespoke options by seeding its own ETFs.

In 2019 it combined with L&G and ESG Index provider Foxberry to create the L&G Europe Equity (Responsible Exclusions) ETF which excluded stocks facing long-term ESG issues such as consumer boycotts and environmental hazards.

It tracks companies on the Foxberry Sustainability Consensus Europe Total Return Index, which may have been overlooked previously by simple sector-based exclusion.

Foxberry says more institutional investors are taking this step either as a full service with index providers or via its recently launched foxf9 platform.

It facilitates the crafting of indices for bespoke ETFs but allows asset managers and pension funds to create them independently of Foxberry.

“By utilising existing data subscriptions as well as their own proprietary data, investors can create unique strategies and assess their performance. The platform significantly simplifies the R&D work for the investors,” explains Foxberry Chief Executive Henrik Brunlid. “The key client benefit is that together we are reducing the ESG feedback loop for assessing new potential investment policy decisions, creating more sustainable products as well as the capability to easily monitor ongoing commitments across different mandates and products. They can backtest portfolio models and screen on sustainability parameters.”

Brunlid says there is a “significant pipeline” of new bespoke ETFs set to come into the public domain by the end of this year and early next.

“All large institutional investors have very bespoke views on sustainability across the board,” he says. “How they treat data sources, what they find acceptable and what fits with their long-term sustainability plan. Some may have a very predefined spec of what they want such as weightings for certain ESG groups or stocks. By going bespoke they get exactly what they want both in selection, exclusions and risk-return trade-offs versus other benchmarks.”

Different Preferences

Deutsche Börse-owned index provider Qontigo, which enables its clients to directly design and create custom-built indices and their own ETFs, is also seeing more demand.

“Asset managers and owners do have different preferences,” says Melissa Brown, Managing Director, Applied Research at Qontigo. “Some may want to maximise their exposure only to the environment or governance and overweight better performing stocks and eliminate the bad actors. You can’t offer everything for everybody, but we try and meet their goals.”

An example was the launch last year of the Euro iSTOXX Ambition Climat PAB Index in partnership with Amundi. It includes a requirement that component companies commit to the Science Based Targets initiative (SBTi) and establish SBTi-approved targets to remain in the index.

FTSE Russell, part of the London Stock Exchange Group, is also increasingly working with asset owners and asset managers to develop customised indices for ETFs.

“Investors look at ETFs and tell the providers that they want to do ‘x’, but it doesn’t exist, so they need help to make a customised product,” says Aled Jones, FTSE Russell’s Head of SI Product Management for EMEA. “Most if not all of the innovative ESG products in the last 10 years have come from asset owners looking to customise, such as the Smart Beta Climate Indices we created with HSBC.”

Although not fully commoditised in a traditional sense, a recent example of partnering with investors is the FTSE Russell ‘FTSE EU Climate Benchmarks Index Series’ – a range of climate-themed equity indexes aligned to the Paris Agreement to keep global warming below two degrees Celsius by 2050.

Developed in collaboration with Brunel Pension Partnership the framework applies a “transparent tilt exposure” towards and away from index constituents according to exposures such as fossil fuel reserves, carbon reserves and green revenues.

Interestingly the indexes limit the active weight of banking sector constituents to no more than their underlying index weight. “The banking sector often gets ignored but they finance fossil fuel activities around the world,” says Jones.

Direct Indexing

Qontigo’s Brown also sees growth in direct indexing where investors hold underlying stocks in an index directly in custodian accounts that they own rather than pooled investment structures such as ETFs. The holdings can therefore be customised to meet individual needs.

“This can also help investors meet their exact bespoke sustainability goals,” she says.

One technology provider enabling direct indexing is C8 Technologies.

It explains that direct indexing allows institutional investors to customise an index, creating a totally bespoke portfolio to match their risk, ethical and moral quotas. As a basic example, you could track the FTSE 250 but remove say 17 of the companies you don’t want to invest in.

Chief executive Mattias Eriksson adds: “You can exclude the stocks you don’t want that might appear in a traditional one-size-fits-all ETF. Even with thematic ETFs you get all the components whether you like it or not. Getting customisation is crucial as pension funds are faced with increasing reporting regulations and pressure to have a more ESG focus. By owning the underlying stocks you can also attend annual meetings and use impact investing to vote on ESG issues. It is about being in full control.”

He says that some of the major Nordic pension funds are already following this model and it is targeting interest amongst UK pension funds.

“They are beginning to think about it. Big pension funds with legacy technology issues can be slow to react,” Eriksson says. “But they realise this is the future. I see UK pension funds moving into this in the next 12 to 36 months.”

Access All Options

Brown cautions that there is a risk in being too concentrated on only a few sectors with strong ESG credentials or metrics. “Investors need to decide where they want to be on that trade-off between strict ESG and maintaining a strong market return,” she says. “Most investors don’t want to take on a huge risk against the market.”

Tagliani is confident that in the next couple of years following more ETF product expansion that it will be even easier to buy off-the-shelf products than creating a bespoke index.

“It’s like buying clothes off the rack in a shop. It is easier and less time consuming than getting custom tailoring,” he states. “While an ETF may not be the perfect match for your ESG criteria you will find products that pretty much nail what you want to do and are ready to go.”

Brunlid of Foxberry is equally as confident however that customisation of ESG investing by institutional investors will continue to grow.

“Definitely yes,” he says. “In a lot of cases institutional investors want to create bespoke ETFs because they want other people to jump on the same view of the world that they have. By seeding ETFs, they can shape how investors invest by offering them exposure to their sustainable benchmark.”

Perhaps it is a matter of finding the best solution that fits your criteria and investment policy.

C8’s Global Client Officer David Jervis says the need to meet climate change targets is so pressing that investors need to have diversified options available. “We are not ETF killers,” he says. “Direct indexing is a third new way. Mutual funds, ETFs and direct indexing. Investors can utilise all of them to go green.”

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