While many ESG funds have lagged, strong performance in environmental, social and factors can still reduce investment risks.Getty Images
The hype surrounding sustainable exchange-traded funds (ETFs) has lately proven unsustainable.
ETFs with environmental, social and governance (ESG) slants doubled in assets under management (AUM) from 2020 to the end of 2021, reaching $34.5-billion, a Morningstar Canada report found. A combination of lacklustre performance and ESG backlash has led to these funds losing their shine.
In 2022, several ESG funds underperformed compared with their non-ESG counterparts, leading to net outflows of US$15.4-billion in the United States through the first half of 2023. Canada has similarly seen net outflows in sustainable funds, amounting to $22.4-million in the third quarter of this year – the first quarter of net outflows since early 2020, according to Morningstar.
Critics have likened the ESG investing trend to putting “lipstick on a pig,” says Liz Simmie, co-founder of Honeytree Investment Management in Toronto. She points out that partisan political rhetoric has planted the “woke” label on all sorts of ESG efforts.
It hasn’t helped that some funds with ESG in their names have failed to live up to their marketing fanfare. Ms. Simmie says many investors are correct to have concerns about companies “not walking the talk” and about greenwashing, a practice where a company’s products or operations are not as environmentally friendly as advertised.
Despite the sluggish returns of many of these funds, Ms. Simmie says there remain solid reasons to embrace responsible investing (RI). “We’ve seen a rotation of funds out of ESG products, but that is more the fair-weather ESG investors and advisors, and the more tactical traders. The real ESG investor believes that companies doing bad things are big investment risks.”
She says she remains a believer. Her firm recently launched the U.S.-listed Honeytree U.S. Equity ETF (BEEZ-Q), using ESG criteria to select stocks.
The recent performance of many ESG ETFs has been neither unexpected nor dismaying, says Tim Nash, a certified financial planner with Good Investing Financial Planners in Toronto. “It feels like ESG ETFs are beaten down, but these funds are doing their job.”
As a broad-based, responsible investment (RI) strategy, ESG ETFs have a “high degree of correlation” to non-ESG benchmarks, he says. But due to index construction differences, performances can vary as two comparable iShares ETFs show.
The iShares ESG Equity ETF (GEQT-T) grew nearly 23 per cent in 2021, and declined about 16 per cent in 2022. In contrast, the iShares non-ESG Core Equity (XEQT-T) grew about 20 per cent in 2021, while dropping about 11 per cent in 2022. The performance difference is largely due to oil and gas exposure, Mr. Nash says. GEQT has no exposure to energy, which outperformed last year, while XEGT does.
He adds that recent ESG ETF outflows do not mean ESG is failing. Equity funds in general have seen outflows. Morningstar has noted that long-equity ETFs overall saw a US$4.1-billion reduction in AUM in the third quarter of 2023.
Still, the recent underperformance of sustainable equity ETFs has left some investors questioning ESG, especially those who first invested at the 2021 market peak, says Douglas Chow, CEO of PortageBay, a Toronto-based ESG analytics provider.
For example, $10,000 invested in CIBC’s Clean Energy Index ETF (CCLN-NE) at its launch in late 2021 would be worth about $4,300 today, Morningstar data shows.
Some investor disappointment stems from confusion between broad-based ESG ETFs and narrower thematic ETFs such as clean energy funds, says Mr. Chow. He adds the industry can also do a better job of showing how progress in certain ESG factors pays off.
Many strategies ETF providers employ don’t connect ESG measures such as emissions reduction, water conservation and board diversity as well as they could with financial performance. Companies leading in these areas tend to outperform financially, he says.
Some investors might also fail to understand the underlying index construction. When you buy a climate leaders ETF, “you basically own the S&P 500″ with slightly different weighting, says Mr. Chow.
The iShares ESG MSCI USA Leaders ETF (SUSL-Q), for example, has about 200 fewer basis points of AUM allocated to energy companies than the iShares S&P 500 Core ETF (IVV-A), arguably a non-ESG benchmark, he says. “You still own some ‘dirty’ companies, but you don’t own as many of them.”
For investors seeking broad-based, low-cost RI strategies, ESG ETFs “are still super useful,” says James Dunne, managing director of Markdale Financial Management in Toronto, a multi-family office representing clients with ESG mandates.
He says some investors may not realize the extent to which the exposure in ESG ETFs varies. Some use negative screens, such as removing oil and gas companies. Others employ integration, where energy firms with strong ESG scores are included.
“They’re doing a little bit less evil while being a little more aligned with people’s values,” says Mr. Nash.
ETFs that rely heavily on ESG ratings, consolidating hundreds of indicators, still may not align well with investors seeking to move the needle on climate change, for example.
A small but growing selection of actively managed ESG ETFs, analyzing ESG and financial metrics to uncover leaders on both fronts, is garnering interest, Mr. Nash says.
That includes NBI’s Sustainable Canadian Equity ETF (NSCE-T), an active fund launched in 2020 that declined less than 2 per cent last year, with no oil and gas exposure. Honeytree’s BEEZ marks yet another choice among active ETFs, Mr. Nash adds.
Whether passive or active, ESG ETFs are unlikely to fade away, says Ms. Simmie. If anything, they are more likely to become a prudent strategy for all investors as ESG reporting and regulations are increasingly formalized. “Simply put, ESG will be much harder for investors to ignore.”