Ethical pressures boost ESG funds

While the total of assets under management in environmental, social and governance (ESG) funds is still small, the category has become an increasingly popular smart beta strategies.

ESG assets under management have grown the fastest among smart beta strategies, at a compound annual growth rate of more than 70 per cent over the past five years, according to a recent report from Bank of America Merrill Lynch.

ESG has topped other popular smart beta strategies such as low volatility or momentum investing, the report said.

The broad market for sustainable investing, from green-bond funds to impact investors, has surged in 2019. For the three months to September, investment flows into US open-end and exchange-traded sustainable funds surpassed $4bn for the third quarter in a row, according to Morningstar.

Smart beta appears to be a key driver for the growth in ESG investments in recent months. For example, the iShares ESG MSCI USA ETF drew in about $900m in September, almost quadrupling the fund’s total assets from $296m to $1.2bn in one month, according to Bloomberg data. “There has been a sea change and I think it is all driven by the availability of more and better data,” says Savita Subramanian, head of US equity and quantitative strategy at BofA.

Portfolio managers of actively managed ESG funds may go to companies to discuss with executives the business’s environmental impact, but ESG-themed smart beta funds rely on data from sustainability reports and third-party providers to populate a portfolio, Ms Subramanian says.

Demand for smart beta ESG products is starting to come from pension funds. Pressure from governments to adopt ESG strategies is also helping, says Bruno Taillardat, head of smart beta at Amundi.

More fund managers are becoming interested in ESG investing so long as it can prove its worth, says Mr Taillardat. “They want to make sure they . . . do not leave some return on the table,” he says.

The strategy often used involves excluding companies altogether in sin stock categories while “tilting” or overweighting companies with high ESG scores.

Investors are turning to environmental, carbon and governance data to build smart beta strategies, according to a report published in September by Sustainalytics, an ESG data provider, the Oxford university and Aberdeen Standard Investments.

Information about a company’s carbon footprint was cited as a leading ESG metric for smart beta but several investors surveyed for the report said the lack of historical data and limited disclosure by companies remains a major impediment to the growth of smart beta ESG.

For now, negative screens account for about two-thirds of smart beta ESG strategies, the report said.

“While much of today’s smart beta ESG market is dominated by relatively straightforward ESG screens, we expect the space to evolve rapidly, given the amount of quantitative testing taking place behind the scenes,” says Doug Morrow, director of thematic research at Sustainalytics.

Opportunities to pursue ESG smart beta strategies are growing. In July, Italian bank UniCredit launched its first two ETFs that combine smart beta and ESG criteria.

One of the funds is designed to beat market returns while adhering to an index that excludes companies subject to controversy because they produce weapons, thermal coal, nuclear power and tobacco.

Both indices are based on the Euro Stoxx Index and apply ESG exclusion screens from Sustainalytics that broadly follow the UN Global Compact principles for human and labour rights, the environment, business ethics and opposing corruption.

The risks associated with ESG smart beta lie in the quality of the data that determine how much stock in a company the fund should buy or seek. A top concern is that the screening data from Sustainalytics, MSCI, or other providers that are used for these strategies, could go awry.

“Just like credit ratings, ESG ratings are susceptible to all sorts of problems,” says Ms Subramanian.

Additionally, a selling stampede can occur when “darling” ESG companies, that have been overweighted by an ESG smart beta fund, are hit by a scandal. “It is really interesting to see that the attrition out of controversy stocks with high ranks is violent and scary,” she says.