Exchange-traded funds have become the default choice for many to gain exposure to a new investment proposition. And purveyors of ETFs haven’t been slow to move into the environmental, social and governance space.
However, the funds have their own risks, such as tracking errors or mistaken country or sector bets, an obvious risk for thematic ESG ETFs. Sceptics are also critical of the appropriateness of ETFs for sustainability-focused investing. Short-termist, and above all passive, most ETFs do appear ill-suited to an investment proposition that urges active engagement, with investors just following the index provider’s creation.
There are also concerns about the index creation, a business that the ratings agencies have piled into since the global financial crisis – which, if you recall, was substantially blamed on their lack of independence, beholden to the funds and firms which they rated.
Look, for example, at Moody’s ESG Solutions, which “enables index providers, investment banks, asset owners and asset managers to develop custom indices, structured products, benchmarking, ETFs, derivatives and other index-related products”. How independent and objective are the resulting indices likely to be? Aren’t they going to be inexorably tied to the interests of the investment banks and other product developers promoting them?
Yes, ETFs have low costs and fees. And yes, ETFs are transparent and easy to move in and out of. But the cost and fee issue hasn’t stopped institutional investors from piling into private equity, one of the most notoriously high-fee and high-cost asset classes around, and also notoriously opaque, with long lock-ups. So it seems that institutions are ready to pay more (and know less, and wait longer) when they feel the results are justified.
It seems that investors have got into the habit of opting for ETFs without thinking, and that many of their advantages are historical and need reassessment for the times. In an environment of high volatility, macro uncertainty and rising inflation, is a passive index-tracking asset whose main virtue is low cost really the type of asset class you want? If you’re ready to pay more for private equity, why not for actively managed public equity funds?
Above all, if you’re looking to achieve positive ESG results versus just making your portfolio look green, is passive investment really the way to go? There are patently more active approaches, all the way to activist investment.
ETFs can be one of several instruments in the toolbox to deliver ESG goals. Their shortcomings definitely need to be considered alongside their advantages. A little self-assessment by investors of their own biases, assumptions and ingrained habits wouldn’t come amiss either.
