Analysing ESG ETFs

Morningstar passive fund analysts have come up with a new way to categorise sustainable funds, making it easier for investors to make portfolio decisions

Emma Wall 22 May, 2018 | 7:45AM
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Emma Wall: Hello, and welcome to the Morningstar series, "Ask the Expert." I'm Emma Wall and I'm joined today by Morningstar's Kenneth Lamont to talk about ESG investing and passive investing.

Hi, Kenneth.

Kenneth Lamont: Hello, Emma.

Wall: So, those two areas of the investment world – big growth areas of the investment world, both of those – they can seem to some mutually exclusive, but they are not, are they?

Lamont: Quite the contrary. The rules-based foundations of passive investing is well suited to the exclusions used in ESG or sustainable investing.

Wall: Does that mean that ESG ETFs are a type of strategic or smart beta ETF?

Lamont: Well, under our current definition, no. However, you have touched on, sort of, an interesting point. There is an ongoing search for an ESG factor. The idea behind this is that actually looking forwards there is a financial risk. You can improve your financial risk and reward by investing sustainably. If you look at companies like VW or BP, you can see there are financial implications for not considering sustainability.

Wall: Now, ESG is a topic that can be quite subjective. It can be very personal. What ESG means to one person may not be the same as it does to another. So, how do you as a fund analyst go about analysing these ESG ETFs?

Lamont: Well, actually, in-house we have our own globe rating system, which analyses a fund against its entire peer group on ESG criteria. And in our recent report that we just published, you can see that actually over 70% of the global passive ESG universe is above-average or has a high ESG scoring.

Wall: So, there is consistency there in the messaging and in the delivering of that messaging?

Lamont: Yes, there is. Yeah.

Wall: And so, how do you then, I suppose, silo this new broad range of funds? Because when I first started writing about ethical investing, we used terminology such as dark green or light green, you know. Dark green was very negative screened, very, very ethical. And then light green was the more sort of positive discrimination, best-of-bunch in terms of ethical investing. But those terms are old-fashioned now, aren't they? And you've come up with a sort of new way in which to silo and identify the different products?

Lamont: Well, yes. I mean, certainly, the market has developed, it's matured or it is maturing. And alongside that, the way we look at the market is also matured. And certainly, in the most recent paper we've done, we look at specifically a passive sustainable investing. And we've created three distinct buckets in which these funds fall. On the one end, you have broad ESG, which is, these funds might replace a core holding like an S&P 500, but they integrate environmental, social and governance factors.

On the other end, we have narrow thematic. These might be sort of a new energy fund, so investing in wind farms and the like. And in the middle, we have a separate bucket called broad thematic. So, this is still focused on a single theme; for example, gender. But it's applied rather to a single sector, again, to the broad universe. So, for example, a gender ETF, which would score companies across the broad universe on gender criteria.

Wall: And that, that categorisation alongside the globe indexes that we have here at Morningstar should help investors to make more informed decisions about their ESG-focused portfolios?

Lamont: Well, certainly, it's very powerful. The intentionality of a fund and its output are separate. But with these two tools you can actually view both of them through the same lens.

Wall: Kenneth, thank you very much.

Lamont: Thank you, Emma.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

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Emma Wall  is former Senior International Editor for Morningstar

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