The reasons why ESG ETF demand is soaring

While ESG investing is increasingly popular, the process of ESG ranking appears to still need some development.

The appeal of sustainability-focused exchange-traded funds (ETFs) continued in the first quarter of 2021, with billions of dollars pouring into such funds in Europe.

According to the Financial Times, during the first quarter of 2021 environmental, social and governance (ESG) focused ETFs saw more inflows than all other ETFs in Europe. Data from Morningstar showed that a record $25.8 billion (£18 billion) was invested in ESG ETFs in the first three months of the years in Europe. In contrast, $22.3 billion was invested in non-ESG ETFs.

This was first time that ESG-focused ETFs received more in inflows than non-ESG focused ETFs. Just two years ago, ESG ETF inflows accounted for around a sixth of all inflows. ESG-focused ETFs account for 10% of the ETF market in Europe, data showed.

Last year saw a surge in interest in ESG-funds, including ETFs. Data from TrackInsight showed that passive funds using at ESG index saw assets rise from $59 billion to $174 billion.

This has been driven by several factors, including increased investor awareness, regulatory compliance and expectations of outperformance. There has also been a renewed focus on environmentalism from the US and other governments, which also appears to be pushing investors in the ESG direction.

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Major index providers are also increasingly offering ESG-screened versions of their major indices. MSCI has been at the forefront of this in recent years. However, most recently, S&P Dow Jones Indices announced that they would offer ESG-screened versions of their popular ‘dividend aristocrat’ indices.

However, while ESG investing is proving increasingly popular, the actual process of ESG ranking appears to still be in need of some development.

According to academics Elroy Dimson, Paul Marsh and Mike Staunton in their 2020 version of the Credit Suisse Global Investment Returns Yearbook, 36% of money in ESG funds is within a fund that uses a so-called negative/exclusionary screening approach. This approach typically means excluding so-called sin stocks, such as tobacco, alcohol and gambling. Generally, it is blunt but rather simple.

But now, many index and data providers take a different approach. Instead of screening out ‘sin’ stocks from an index or portfolio, they opt to rank certain companies according to their E, S and G credentials, assigning them a score that then determines their weighting.

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According to the academics responsible for the annual Credit Suisse Global Investment Returns Yearbook, there is a troubling level of subjectivity involved in all this. In the report, they document that a company receiving a good ESG score from one data provider had very low correlation with receiving a good ESG score from others. This lack of correlation was most pronounced when it came to governance.

This means that there appears to be very little agreement between ESG data providers on what exactly constitutes a good company from an ESG perspective. A company may receive a good score from FTSE but a poor score from MSCI.