The meaning and use of “ESG” is still in development. As the number of financial products with an environmental or humanitarian focus grows – including specialist ESG indices and ETFs – the range of criteria they use often contributes to confusion about the category. More than 17 years after the appearance of the term, fundamental questions persist about ESG. When is an “ESG” product sufficient to earn the label? What is the status of the ESG market and where is it going? Are ESG products as good as their closest non-ESG counterparts?
For high-level insight on these and other questions, we asked Rebecca Chesworth, senior equity ETF strategist at SPDR ETFs, and Zubin Ramdarshan, head of equity and index product design for Eurex, to share their thoughts on the dynamic ESG universe.
ESG is changing as we speak. Where is the market now and where is it going?
Rebecca Chesworth: Across all ETFs, we’ve had record flows this year – and 50% of those flows have gone to ESG funds. ESG is therefore no longer a niche and is no longer a novelty. It is becoming commonplace, which means that many of the principles used in ESG investing will be used elsewhere. ESG will cease to be a ‘good to have’ and some ESG exclusions will likely become the norm. The trend to exclude cluster munitions is one example. In the future, new regulations in the United States and Europe will also force many additional investments to comply with ESG standards.
Zubin Ramdarshan: The first ESG phase started a few years ago and looked at products for negative screening or standards-based screening. There were typical exclusions based on controversial weapons, tobacco and the principles of the United Nations Global Compact. At this entry point, there was broad agreement that this was a baseline ESG methodology. This phase culminated in our most successful product to date, the STOXX Europe 600 ESG-X Futures.
We are currently in phase two, which involves adding ESG integration and positive screening methodologies to our suite of index derivatives. This means incorporating ESG scores that actually improve the risk-return profile of the index, and including companies that have the best relative performance or are best-in-class on an ESG by sector basis.
We plan to launch phase three in early 2022, with a focus on SRI and a focus on impact investing. We will also look at the SDGs (Sustainable Development Goals), climate transition benchmarks, Paris-aligned benchmarks and others in this next phase.
What factors affect the adoption of certain ESG products?
Zubin Ramdarshan: Our product STOXX Europe 600 ESG-X Futures has been very successful because of its simplicity; you’re just cutting out the bad companies, basically. Our current phase, moving to ESG integration with positive screening, adds complexity that must be explained to the end customer. What does this mean in terms of methodology? And the weighting, if there is sector bias? There has to be education before adoption can take off.
Rebecca Chesworth: I am okay. When our industry started talking about ESG, people just wanted to know more about performance. What were the potential returns or tracking error compared to a parent benchmark? Now they want to know the ESG score, what they are getting in the product, and what index it tracks. Product choice has become much more about investor, asset manager and brand values. This story is evolving rapidly and I agree that we are in phase 2.0. But there will be 3.0 and maybe more beyond.
What do you think about the difference in performance of ESG products compared to non-ESG products?
Rebecca Chesworth:Bank of America released a statistic at the end of September 2021 showing every ESG index they looked at around the world, 61% of them outperformed the parent index and 70% out of three. years. This is a real turnaround from a decade ago, when it took a big sales effort to convince people that they weren’t giving up too much performance to do something good for the company. , the environment, etc. Today, investors are almost expecting a slight outperformance from ESG Products.
This could be partly due to exclusionary strategies – energy stocks can be an example. However, there is no reason why an ESG strategy or index should not outperform, because if it considers all the risks more carefully, then, at the very least, you are removing some risks. So the conversation has changed for the better over the past decade.
Zubin Ramdarshan: The difference in performance of ESG products versus non-ESG products will be further explored in the future. As Rebecca mentioned, how much of the strong performance can be attributed to sector bias? There is a common belief that ESG indices performed well because of their higher technological weight or lower weight in, say, energy producers during a time when the price of oil was under pressure. And to what extent can the outperformance be attributed to the simple fact that more money was invested in ESG products rather than non-ESG choices? On the other hand, to what extent could negative performance have been mitigated by faster exit rules – or by quickly removing a company from ESG indices when its score drops? There are no clear answers yet.
But beyond these uncertainties, I think there is a valuable signal in ESG. For example, MSCI research suggests that a company’s G score is highly relevant in emerging markets, and it makes sense for a company with strong governance to outperform.
When is an “ESG product enough? Will we get to a point where we’re comfortable understanding what the long-term expectations and rules will be?
Rebecca Chesworth: I think as an industry we will keep trying. Index providers are constantly innovating. They buy up rating and rating companies and continually increase their capacity to produce ESG indices. Fund providers want to launch more products and customers want to buy more to match their brand values. All of these factors will continue to push for change.
Naturally, the changing regulatory landscape is one of the main drivers of change and determining when products are “ESG enough”. The SFDR (Sustainable Finance Disclosure Regulation) alone is forcing big changes in Europe, and we will also see huge regulatory changes in the United States in the years to come.
Zubin Ramdarshan: Standardizing ESG criteria becomes more difficult as complexity increases. Will there be a market-determined consensus, or will index providers be forced to align with a standard approach? I do not know. But I don’t think standardization is a good end point. You want room for innovation and creativity given that ESG is still so new. Creating a menu of choice is a better goal. We want to give our members and clients the choice between two or three different flavors of ESG, to appeal to as many audiences as possible.
What is your position on the debate between active and passive management underway in the ESG space?
Zubin Ramdarshan: We are not taking a position, but we recognize that the trend is towards passive asset management in general. So we want to offer a menu of products that the active or passive community can use. And the slant towards liabilities naturally lends itself to indexation, which plays to our strengths with a strong index derivative suite that already includes 18 index futures and four index options. We are well placed to go passive.
Rebecca Chesworth: I see the trend of index investing continuing, but within ETFs I also see innovation in active ESG developing. More money will be invested in ESG investments through ETFs, as this trend is now unstoppable.
One of the biggest changes over the past 10 years is the realization that you can have GSS in index form. At first, investors only thought about it in active terms, but the big passive houses arose and index providers created innovative solutions. Now index providers and fund managers have to convince investors that we can do the job of asset stewardship as well as active managers.
Are we moving away from investors who want ESG as a core beta exposure and become more thematic? Where is the ideal thematic and ESG cross?
Zubin Ramdarshan: The word “thematic” suggests that themes are coming and going out of fashion, but I see ESG as a staple of portfolios now and as a long-term structural model. That said, there is certainly an intersection between the themes and the ESG. If you look at the E’s, S’s, and G’s separately, you tackle themes such as water scarcity, women’s participation in the workforce, diversity, green real estate, and many more.
Rebecca Chesworth: I agree that ESG is now structural and not a trend that will go out of fashion, but specific themes within ESG will be of greater importance at different times. For example, everyone wants to talk about the climate now, but by mid-2020 it looked like social themes might take over. I see ESG becoming a natural layer on top of basic beta investing, and we’ll see themes that could become more important than, say, things like value and growth, or styles.
Above all, it is important to remember that ESG is the source of real change. In 2016, State Street Global Advisors launched a fund for gender equality in the United States, made up of companies with boards of directors made up of women. The associated Fearless Girl campaign demanded action, and many companies responded by appointing women to their boards. In 2017, our Fearless Girl statue on Wall Street became a symbol of gender equality in the workplace. It is clear that ESG efforts are making a real difference.
Learn more about ESG investment opportunities.