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ETF, Ratings and ESG; Caveat Emptor

Why don’t I just buy an ESG* ETF with a good sustainability rating?

(… question from a dear friend)

The conclusion I wish to share with my friend, who wants to invest sustainably and profitably through ESG ETFs is:caveat emptor.

ETFs are, amongst other shortcomings, passive vehicles, in that they don’t give you the all-important engagement that is required to evaluate which businesses are sustainable. Many ETFs are agnostic to valuation and they generally ignore concentration risk. Furthermore, rating agencies are frequently being used to give ETFs’ sustainability scores that by themselves and out of context  can be almost meaningless and often may unintentionally be somewhat misleading.

In this month’s Arcus I try to answer the above question and, in the process, also raise a very important flag to the industry as a whole which attempts to provide sustainable and profitable investing solutions: the flag is that we need to be very careful about the quality and integrity of the claims we make because the inherent limits of the data around non-financial capital are significant and more pronounced than the limits of conventional financial data.

Before I go any further and look at the ESG ETFs and their ratings, I should clarify my own claims:

  • As a traditional investor of more than two and half decades, it has only been in the last 5 years that I have started appreciating the necessity to incorporate progress on human, social and environmental capital into my investing, a philosophy I now call Panvesting.

  • As Panvestors we do not claim to measure return on human, social and environmental capital. Instead we identify and track what is measurable, specifically the progress made by companies on human, social and environmental capital.

  • As Panvestors we firmly believe that such progress is likely to lead to improved, more sustainable financial returns.  However, we do not have the statistical proof of causation - yet.

  • As Panvestors it is the incremental improvements made by companies with respect to their financial, social, human and environmental capital that attracts us; it is not some absolute level, rating or ranking that justifies our portfolio positions.

  • As Panvestors we know that our portfolio companies are not perfect. But given their focus on all stakeholders we do expect them to swiftly rectify things that go wrong.

  • As Panvestors, while our philosophy and framework are grounded in theory as well as experience, we know that just as practices, metrics and standards around non-financial capital evolve, our process will need to evolve as well. We, too, need to progress.

Now looking at claims made by others as I turn to the first part of my friend’s question,“Why not an ESG ETF...?"

There is no standardised definition of ESGand ESG ETFs are of many shades of sustainability. The ETFs’ we will look at are unnamed but real.  We look at ETFs from across the whole spectrum, from Non-ESG to ESG Enhanced.

Specifically, we review the following ETFs:

  • US Aerospace & Defence ETF (What ESG?)

  • World ETF (Non ESG)

  • Core FTSE 100 ETF (Non ESG)

  • World ESG Screened ETF (ESG filter used)

  • World ESG Enhanced ETF (ESG filter plus process applied) 

The first is the most obviousNO GOfor anyone interested in ESG, the next two are traditional ETFs with some non-specific ESG focus and the remaining two claim to have progressive ESG credentials.

ESG ETFs … what is in them?

Amongst ESG investors exclusion of certain sectors is seen as the most basic form of ESG investing. The three sectors that generally get excluded are:Weapons, Gambling and Tobacco, because of their purported negative social impact.

My friend should know how her ETF invests in these 3 sectors...

Source: iShares ETF Factsheets and company disclosures 

From the above table, it is no surprise that theUS Aerospace & Defence ETF, with its 33 stocks, is 100% in weapons. What is somewhat surprising is that 4.3% of assets under management (AUM) and 91 of 1,316 stocks of theESG Enhanced ETFare in these sectors, which is higher than the simplerESG Screener ETF.ESG Enhanced, as the name suggests, is meant to be more focused on ESG than theESG Screened ETF. The obvious question is...

“Why do these ESG ETFs have any exposure to these socially challenging sectors at all, and if they do, what is the policy or reason behind it?”

Up until now we have used a very narrow definition of ESG, namely the S (Society) in ESG and the three socially questionable sectors to review some common ESG ETFs. My friend may want to go a little further and see the E (Environmental) credentials within the ESG ETFs. So, let’s peel away another layer of the above ETFs.

Source: iShares ETF Factsheets and company disclosures 

The traditional non-ESG ETF, ESG Screened ETF or ESG Enhanced ETF all have around 4% of their stocks and approximately 5.0% of their AUM in oil and fracking. Once again, theESG Enhanced ETFactually has a higher exposure than theESG Screened ETF. Exposure to oil and gas in itself does not necessarily contravene ESG investment principles. However, to differentiate between ESG and Non-ESG, the former should have a policy concerning environmentally challenging investments such as oil production and fracking. The execution of such a policy would require supporting analysisbacked by engagement. Here we run into an inherent shortfall of ETFs: they can not, and therefore, do not give you that engagement. ETFs are passive vehicles; they piggyback on the hard engagement yards done by active managers. 


To finish this review, I discuss the second part of my friend’s question“…an ESG ETFwith a good sustainability rating.”

Let’s look at ratings such as the MSCI ESG Quality Scores which are often quoted by ETFs and active funds to help them highlight their ESG credentials.

To underline the challenges of sustainability ratings and their application, I introduce theFTSE 100 ETF, a non ESG ETF, and compare its exposure to the three socially challenged sectors plus fossil fuels to theESG Screened andESG Enhanced ETFs. A relative comparison of the ESG Quality Scores of these ETFs highlights caution against relying on absolute scores.

My last table for today…

Source: iShares ETF Factsheets and company disclosures 

The last row of the above table shows that according to MSCI ESG Quality scoring system, theFTSE 100 ETF(Non-ESG) has an ESG Quality Score of 6.7, well ahead of theESG Screened ETFand just below theESG EnhancedETFat 7, even though it has 8.9% of its assets in the three sin sectors and 24% of assets in fossil fuels including coal. This is to highlight that, in absolute terms, the ESG Quality Scores don’t seem to reflect the ESG credentials of the ETFs’ holdings.  

In conclusion, basic ETFs do have a place and do represent a feasible investment option - as long as one is willing to focus on financial factors only.

ESG and sustainability factors cannot credibly be incorporated into an ESG ETF because passive investing which represents a process without engagement, a process which is agnostic to progress on non-financial capital, will invariably create a portfolio of companies that cannot pass the basic sustainability credentials as we interpret and apply them.

At Panarchy Partners, we believe that traditional investing needs to evolve and begin incorporating all forms of capital. This broadened focus will benefit all stakeholders, including shareholders who are likely to enjoy more sustainable returns.

We intend for Panvesting to go beyond the well-intentioned ESG migration away from legacy investments.

Acknowledgement should be given to our interns for all of the hard work and contributions made to research this summer especially Aadil Siddiqi for his work on ETFs. 

Happy Panvesting!

Munib Madni,

Founding Panvestor 

*ESG – Environment, Social and Governance. A term used in Finance, interchangeably with sustainability.


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