Why is my environmentally friendly ETF overweight Rio Tinto?

Tom Bailey explains why Rio Tinto is one of the biggest holdings in two ESG-focused ETFs. 

Ethical and sustainable investing is all the rage right now. This trend has been felt in exchange-traded funds (ETFs) too, with the amount of money invested in so-called environmental, social and governance (ESG) ETFs roughly doubling in 2020. 

These ETFs typically invest in indices that apply a screen, stripping out certain stocks and re-weighting others. However, as ever, investors in this trend should pay close attention to what they are actually investing in, with some ETFs investing in stocks that many might not expect to see in an ESG fund.

For example, take the Xtrackers MSCI ESG UK UCITS ETF (LSE:XASX), which tracks the MSCI United Kingdom IMI Low Carbon SRI Leaders Select Index. Perhaps surprisingly, the ETF has a weighting of 6.4% to the mining giant Rio Tinto (LSE:RIO) (as of 30 December 2020).

That means that Rio Tinto is the ETFs third-largest holding. Its position in Rio Tinto is also bigger than that of its parent index, the MSCI United Kingdom IMI index, which has a weighting of 3.1%. Therefore, the ESG-screened ETF has a roughly double weighting towards Rio Tinto. 

It is a similar situation with the Amundi MSCI UK IMI SRI ETF GBP (LSE:FT1K). This ETF tracks the MSCI UK IMI SRI Filtered + ex Fossil Fuels Index, giving Rio Tinto a weighting of 5.3%. At the end of December, Rio Tinto was the ETFs second-largest holding.

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The overweight of Rio Tinto may come as a shock to many ESG-inclined investors. Rio Tinto is involved in mining, which is usually associated with environmental costs. However, instead of excluding this stock, the two above-mentioned ESG ETFs give investors a bigger exposure to the company.

Why do the two ESG ETFs have Rio Tinto as one of their biggest holdings?  

It all comes down to how many ESG indices are constructed. Older “ethical” or “environmental” approaches to investing would just exclude certain “sin stocks”. However, the ESG approach is slightly different, with companies scored on their ESG credentials in comparisons to other stocks.

In the case of the indices that the two ETFs mentioned track, stocks are scored against others in their sector. As a result, the best stocks in some sectors will still be included, even if they are not ones typically associated with ESG-style investing.

As Kenneth Lamont, senior analyst of passive strategies at Morningstar, explains: “The methodology employed by the Xtrackers and Amundi funds ranks all stocks in the universe (UK MSCI IMI in this case) by their ESG scores and then invests in the top quartile of those stocks by sector.”

As a result, Lamont points out that plenty of other mining stocks are excluded by the ETFs, including big names such as BHP Group, Anglo American, Glencore and Fresnillo. It is simply the case that MSCI scoring puts Rio Tinto ahead of its peers in the mining sector.  

There is a good reason for this approach: the index is constructed so that it, and any ETF that tracks it, does not end up deviating too far from the parent index, the MSCI United Kingdom IMI index.

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The point of the two ETFs mentioned is to give exposure to the highest ESG-scoring core UK equities, as opposed to providing exposure to stocks deemed environmentally friendly. As a result, there is a trade-off between the screened index still having some resemblance to the parent index and ESG purity.

Lamont says: “They exclude almost all energy holdings and the majority of mining companies, which would be good enough for many investors. If an investor sees these stocks like a fly in their soup, then there are other funds out there that will cater to their needs.”

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.