Morningstar analysis has found a number of ethical and social ETFs own the very stocks they claim to exclude – and conscientious investors could be in the dark about their holdings, amounting to hundreds of millions of pounds. This contradictory state of affairs is made possible by the use of synthetic replication.
To many ESG investors, this may feel like discovering meat in a vegetarian burger
Let us take the Amundi ETF MSCI World Low Carbon UCITS ETF (LWCU) as an example. The index it tracks screens all constituents of the MSCI World index and excludes those with the largest carbon footprint.
Yet, at the time of writing, the fund holds stocks like Belgian brewer Anheuser-Busch InBev or German pharma-giant Bayer, which have been specifically excluded from underlying index because of their relatively large carbon emissions.
A look at other providers reveals that Lyxor’s Finvex Sustainability Low Volatility Europe UCITS ETF (FINE) is also permitted to hold stocks which have been specifically screened out on ESG grounds.
How Can Ethical ETFs Hold Unethical Stocks?
In order to explain this paradoxical situation we need to pull back the curtain and take a closer look at how these ETFs are constructed.
The Amundi MSCI World Low Carbon ETF and the Lyxor Finvex Sustainability Low Volatility Europe ETF are both synthetically replicated. Under the synthetic model, a fund enters into a swap agreement with a counterparty, generally an investment bank, which commits to deliver the performance of the index. In exchange, the fund receives ownership of a basket of securities.
The securities held by the ETF are subject to strict UCITS rules and high quality screens, but they may bear little resemblance to the index constituents. And, as we’ve seen in the case of the two ETFs in question, they may be the very stocks that the index had actively excluded. For a more in-depth look at how synthetic ETFs are constructed I recommend a previous article we published on the topic.
This potential for conflict between the index and the fund’s actual holdings has been recognised by Morningstar and underpins the decision not to award synthetic ETFs a Morningstar Sustainability Rating.
Does it Matter?
Well, to many ESG investors, this may feel like discovering chunks of meat in a vegetarian burger.
Synthetic fund providers may argue that, as with any ETF, what really matters is the exposure, i.e. the index, that these funds provide access to, and that the fund’s actual holdings are only there to mitigate swap counterparty risk.
However, it’s hard to escape the feeling that in this circumstance, Amundi and Lyxor are failing to properly acknowledge the deep-seated set of beliefs held by ESG investors and which, logically, would call for the exclusion of non-compliant stocks at all levels of the replication process.
Can Synthetic ETFs Ever Be Ethical?
Synthetic ETF providers are certainly capable of tailoring their guidelines to suit the sensitivities of any given group of investors. And in fact, some are already doing so. For example, db X-trackers imposes fund-specific collateral requirements for its synthetically replicated Shariah-compliant DJ Islamic Market Titans 100 UCITS ETF.
The fund’s holdings are subjected to the same Shariah compliance as the underlying index. Hence, there is nothing theoretically stopping synthetic providers from including specific instructions, such as ESG filters, for their suite of ESG ETFs.
The good news for the ESG-conscious is that, as synthetic ETFs have come under increasing scrutiny in recent years, the transparency offered by providers has improved markedly. All three of the providers mentioned above currently post the actual funds’ holdings on their respective websites on a regular basis. This allows investors to make their own decision regarding both the quality and nature of what they actually own.
