Avoiding ‘sin stocks’ is no longer enough for ESG ETFs

Traditional socially responsible exchange traded funds that rely on simply excluding “sin stocks” and other securities linked to sectors such as coal mining or tobacco look set to become a thing of the past, data show.

Instead, investors are leaning towards so-called positive screening approaches that choose best-in-class companies which score high on specific environmental, social and governance performance criteria, according to experts on the rapidly expanding ESG ETF investment industry.

Positive screening was the preferred approach for 45 per cent of investment professionals surveyed by Edhec Risk Institute in a report published on Thursday. That compares with just 30 per cent who preferred thematic approaches — restricting investment choices to companies that score highly on gender diversity, or to those producing green energy for example — and 25 per cent who said they would opt for the simple exclusion, or negative screening, approach.

“A few years back when we were talking to investors, negative screening was the first choice,” said Veronique Menou, head of ESG indexes for Emea at MSCI, the index and ratings provider.

She said that pure negative screening now represented only about 4 per cent of the $55bn of assets linked to MSCI’s equity ESG indices.

Data collected by TrackInsight also suggest this change in heart on how to approach ESG investing is already well under way.

Of more than 400 ESG ETFs the data provider examined, representing $83.5bn in assets under management by the end of June 2020, pure exclusion was the least popular strategy representing only $1.8bn in assets under management and attracting only $1.6m in new inflows since the start of the year.

This compares with inflows of $6.4bn to thematic funds, $6.1bn for best-in-class and $15.8bn for funds that invested in ETFs that integrate ESG factors into investment selection using positive screening alongside exclusion approaches.

Ms Menou said that the inflexion point appeared to have come around 2018, when a report from Eurosif, which tracks sustainable investment, noted the first small decline in assets allocated to a pure exclusion approach. She said regulation had been a key driver of the shift, but that better data and the ability to show long-term performance had also contributed to the growing popularity of best-in-class investing.

Lionel Martellini, professor of finance at Edhec Business School, said he was not surprised to learn that investors were ditching the pure negative screening approach. Not only can deliberately choosing companies that have good socially responsible credentials have the potential to improve the ethical appeal of the ETF, but it also reduces tracking error, he said. Tracking error occurs when the performance of the ETF diverges from the benchmark it is supposed to be tracking.

“With best-in-class you try to keep the same exposure as your benchmark,” he explained.

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