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Published on 4 May 2021
Irene Bauer
Irene Bauer
Algo-Chain, Co-Founder
European Equities
ETF Region

The Rise of ESG Investing

ESG has well and truly entered the mainstream investment landscape. Not a day goes by that doesn’t have an article on ESG. Europe is one of the forerunners in ESG and so it is for equity exposure to Europe, the Eurozone or any individual European country.

Let’s first start with cost. At the time of writing, May 2021, the cheapest European ESG Equity ETFs had a TER of 12bps whereas the most expensive one came in at 41bps. So, what do I get for my money? One of the ETFs at a cost of 12bps is the HSBC USA Sustainable Equity UCITS ETF. This is what I would call an ESG Tilt. In actual fact, it provides a tilt to ESG, carbon emissions and fossil fuel reserves while at the same time trying to stay not too far from the underlying, more traditional non-ESG index. The other ETFs at 12bps are iShares ESG Screened ETFs on several European indices. ESG Screened means negative screening, which filters out companies that are involved in controversial weapons and civilian firearms, tobacco, thermal coal, etc. It does not however weigh the underlying companies based on any ESG scores.

Which brings us to the question what ESG actually means and the proliferation around the many definitions. At Algo-Chain we have devised a classification for all ESG ETFs to shine some light on to the forest of ESG. There are several providers that provide the ESG ratings for companies, for example Sustainalytics, MSCI, FTSE and SAM. While they do not provide exactly the same scoring for each company, the type of methodologies can be seen as represented by five different classifications.

Environmental, Social & Governance ETF Classification

As the number of funds within the ESG category rapidly increases, the challenge of keeping on top of the various classification schemes cannot be underestimated and none more so than in the world of passive investing. Fortunately, most ETFs are constructed in a transparent way and are benchmarked against well documented index methodologies.

In this brief section we outline our in-house ETF classification scheme that allows a Financial Advisor or Wealth Manager to quickly gain a high level understanding of which ESG-centric investment themes & methodologies have been selected within the model portfolio.

ESG Investing

Environmental, social, and governance (ESG) criteria are proving to be an increasingly essential way for investors to evaluate companies in which they might want to invest. ESG criteria can also help investors avoid companies that might pose a greater financial risk due to their environmental or other practices. An ESG fund’s target is to generate long-term competitive financial returns and positive societal impact.

ESG investing is sometimes also known as Sustainable Investing or Socially Responsible Investing (SRI).

The ESG of Investing

ESG funds select companies that score high on all three factors, Environmental, Social and Governance, relative to their industry peers. These factors usually look at a broad range of behaviours.

Environmental criteria consider how a company performs as a steward of nature. Factors can include a company’s energy use, managing resources and preventing pollution, and a good treatment of animals. It may also include any environmental risks a company might face, for example issues related to the disposal of hazardous materials or emissions. One can also find funds that invest in companies that are aligned to the Paris Climate Agreement.
Social criteria examine how a company manages its relationships with employees, suppliers, customers, and the communities it operates in. Examples address issues such as, does the company donate a percentage of its profits, do the working conditions show high regard to its employees? It will also look at how a company works within its community.
Governance deals with a company’s leadership, executive pay, audits, internal controls, and shareholder rights. Does the company avoid conflicts of interest among their board members, does it use political contributions to obtain favourable treatment, or what is the gender balance across their leadership? Issues with governance are a clear risk to a company, as could be seen for example with the BP oil spill or the Volkswagen Dieselgate affair, where in each case issues with governance had been raised before the actual disaster happened or had been uncovered.

Positive Versus Negative Screening

Many ESG funds apply both positive and negative screening methods. The first step is often to screen companies based on their environmental, social and governance factors based on a range of sub-factors. For example, the top 25% or top 50% of all companies in any one sector might be eligible for the fund. Negative screening filters out companies involved in controversial activities like alcohol, tobacco, nuclear weapons and firearms.


ETF Classifications

There are several providers that provide the ESG ratings for companies, for example Sustainalytics, MSCI, and SAM. While they do not provide exactly the same scoring for each company, the type of methodologies can be seen as five different classifications.

Classic ESG: Invests in the top percentile of ESG scored companies, i.e. the top 25% or top 50%. These often come with exclusions to companies with controversial activities. These ETFs are usually called SRI, Sustainable or ESG Leaders.
ESG Light: Seeks a balance between investing in companies that score the highest on ESG and maintaining a similar sector exposure as the original index. Often comes with additional exclusions and popular with Institutional Investors. These ETFs are often called ESG Select or ESG Enhanced.
Exclusions: Negative screening filters out companies involved in controversial activities like alcohol, tobacco, nuclear weapons, firearms etc. These may also be used for Religious themes. These ETFs are often named ESG Screened or ESG Exclusions.
Impact Investing: Targeted investments aimed at solving social or environmental problems to use capital to trigger change for social or environmental purposes. Example ETFs are Green Bond ETFs.
ESG Themed Investing: Exposure to an ESG subsector, like Clean Energy, Gender Equality or the alignment to the Paris Climate Agreement. Individual companies in the fund may not necessarily score the highest on a general ESG ranking. The name of the ETF should be self-explanatory.