ESG ETFs Look to Catch Traditional Rivals

The global exchange traded funds (ETFs) industry continues its exponential growth. This year, US-listed ETFs topped annual inflows records nearly three months before the end of the year. ETFs adhering to environmental, social and governance (ESG) investing principles are playing catch-up relative to their traditional rivals.

Today, there are about 50 ESG ETFs trading in the U.S., but only one, the iShares MSCI KLD 400 Social ETF (DSI), has close to $1 billion in assets under management. Just one other ESG ETF has over $500 million in assets. As of late August 2017, there was about $5.7 billion in combined assets under management at all US-listed ETFs, barely more than a third of the assets managed by the largest ESG mutual fund.

“The relatively small total of assets invested in sustainable ETFs comes at a time when ETFs overall are rapidly expanding,” reported Reuters. “Investors pulled $264.5 billion out of U.S. actively-managed equity mutual funds in 2016, while pumping a record $282 billion into exchange-traded funds, according to data from Morningstar and FactSet.”

A Viable Growth Frontier

Many of this year's top asset-gathering ETFs are low-cost, plain vanilla cap-weighted funds. Still, smart beta ETFs are continuing theirtorrid pace of asset growth as well, compelling some market observers to speculate growth is coming for ESG funds.

The annual ETF industry survey from Brown Brothers Harriman “found greater interest in Environmental, Social and Governance (ESG) ETFs, with 51% of investors finding ESG at least somewhat important vs. 37% last year.”

One of the primary reasons some investors are slow to embrace ESG ETFs is the theory that investing with a conscious can lead to lower performance. While that may true in specific time frames, various data points and studies indicate ESG is viable over the long-term and offers the potential to outperform traditional investments.

Green Business Is Good Business

Companies that prioritize environmental virtues, such as reduced carbon footprints, can be less exposed to commodities prices. By using cost-effective, cleaner energy sources, these companies can save capital and bolster their cash positions. Companies with strong governance track records are often backed by solid management teams that have displayed an ongoing commitment to shareholders and tidy balance sheets. Additionally, these companies are likely to have more diversity on their boards and among C-level executives. Historical data indicate companies with increased gender diversity in key positions outperform male-dominated rivals.

The FlexShares STOXX US ESG Impact Index Fund (ESG) tracks the STOXX USA ESG Impact Index and encompasses a wide array of ESG principles in building its portfolio. ESG's index considers factors such as clean technology, carbon emissions, labor relations, workplace benefits and safety, board policies and executive compensation.

Making Moves to Generate Interest

ETF issuers are taking steps to generate increased interest in ESG funds. Legacy ESG products typically avoid predictable fare, such as gambling, tobacco and weapons stocks. The new generation of ESG ETFs go further and some are refined, focusing on specific niches.

Earlier this year, California-based Inspire Investing launched several ETFs that use Christian values as screens for securities selection. Other ESG ETFs, several of which are proving popular with investors, opt to focus on environmentally conscious companies or firms that emphasize gender diversity to the benefit of investors.

An obvious avenue for generating increased investor interest in ESG is for issuers to compete on fees. This year, roughly three-quarters of U.S. ETF inflows have been allocated to funds with annual expense ratios of 0.2% or less. The average large-cap equity smart beta ETF is significantly pricier, though not expensive at around 0.3% per year.

ETF issuers are showing a willingness to lower smart beta fees or introduce new smart beta fares with low costs. Earlier this year, iShares, the world's largest ETF sponsor, dramatically reduced expenses on several ESG ETFs in what could be the start of lower fees across the ESG space.