The meaning and usage of “ESG” is still developing. As the number of financial products with an environmental or humanitarian focus proliferates – including specialized ESG indexes and ETFs – the range of criteria they use often contributes to confusion about the category. More than 17 years after the term was coined, basic questions still persist about ESG. When is a product “ESG enough” to deserve the label? What is the status of the ESG market and where is it heading? Do ESG products perform as well as their closest non-ESG equivalents?
To get high-level insights on these issues and others, we asked Rebecca Chesworth, Senior Equity ETF Strategist at SPDR ETFs, and Zubin Ramdarshan, Head of Equity & Index Product Design for Eurex, to share their thoughts on the dynamic ESG universe.
ESG is evolving as we speak. Where is the market now and where is it heading?
Rebecca Chesworth: Across all ETFs, we have seen record flows this year – and 50% of those flows have gone into ESG funds. So ESG is no longer niche and no longer new. It’s becoming mainstream, which means that many of the principles used in ESG investing will be used elsewhere. ESG will stop being a “nice to have” and some ESG exclusions will likely become the norm. The trend of moving toward excluding cluster munitions is an example. Going forward, new regulations in the U.S. and Europe will also force many more investments to meet ESG standards.
Zubin Ramdarshan: The first ESG phase began a couple of years ago, and it looked at products for negative screening or norms-based screening. There were typical exclusions based on controversial weapons, tobacco, and the UN Global Compact principles. At this entry point, there was broad agreement that this constituted an ESG methodology at the base level. This phase culminated in our most successful product to date, the STOXX Europe 600 ESG-X Futures.
We’re currently in phase two, which is adding ESG integration and positive screening methodologies to our index derivative suite. This means incorporating ESG scores that really enhance the risk-return profile of the index, and including companies that show relative best performance or are best-in-class on an ESG basis by sector.
We plan to initiate a phase three in early 2022, moving into SRI and emphasizing impact investing. We’ll also look at the SDGs (Sustainable Development Goals), climate transition benchmarks, Paris-aligned benchmarks, and others in this next phase.
What factors are affecting the adoption of some ESG products?
Zubin Ramdarshan: Our STOXX Europe 600 ESG-X Futures product has been extremely successful due to its simplicity; you simply remove the bad companies, essentially. Our current phase, moving into ESG integration with positive screening, adds complexity that must be explained to the end customer. What does it mean in terms of methodology? And weighting, if there’s sector bias? There must be education before adoption can take off.
Rebecca Chesworth: I agree. When our industry first started talking about ESG, people just wanted to know about performance. What were potential returns or the tracking error to a parent benchmark? Now, they want to know about the ESG score, what they’re getting in the product, and what index it’s following. Choosing products has become much more about investor values, asset manager and brand. This story is evolving quickly and I agree we’re in the 2.0 phase. But there will be 3.0 and perhaps more beyond that.
What are your thoughts on the performance difference of ESG versus non-ESG products?
Rebecca Chesworth: Bank of America released a statistic at the end of September 2021 stating of all ESG indices they looked at globally, 61% of had outperformed the parent index, and 70% had done so over three years. That is a real turnaround from a decade ago, when it required a big sales effort to convince people that they weren’t giving up too much performance to do something good for society, the environment, etc. Now investors almost expect some slight outperformance from ESG products.
Part of that could be due to exclusion strategies – energy stocks may offer a case in point. However, there is no reason why an ESG strategy or index shouldn’t outperform, because if it is considering all the risks more carefully then, at the very least, you’re taking some risk away. So conversation has changed for the better over the last decade.
Zubin Ramdarshan: The performance difference of ESG versus non-ESG products is going to receive more scrutiny going forward. As Rebecca touched on, how much strong performance can be attributed to sector bias? There are common beliefs that ESG indices have performed well due to their higher tech weight or their lower weighting in, say, energy producers back when the oil price was under pressure. And how much outperformance can be attributed to the simple fact that more money has been flowing into ESG products rather non-ESG choices? On the other side, how much negative performance could have been mitigated by faster exit rules – or quickly removing a company from ESG indices when its score drops? There aren’t clear answers yet.
But beyond these uncertainties, I do think there’s a valuable signal in ESG. For one example, research from MSCI suggests that a company’s G score is highly relevant in emerging markets, and it makes sense that a company with strong governance would outperform.
When is a product “ESG enough?” Will we get to the point where we’re comfortable that we understand what the expectations and rules will be for the long term?
Rebecca Chesworth: I think as an industry we’ll carry on trying. Index providers are always innovating. They’re buying the rating and scoring companies and continually increasing their capabilities to produce ESG indices. Fund providers want to launch more products and clients want to buy more to match their brand values. All these factors will continue to push for change.
Naturally, the evolving regulatory landscape is one of the biggest factors in driving change and determining when products are “ESG enough.” The SFDR (Sustainable Finance Disclosure Regulation) alone is forcing big changes in Europe, and we’ll see huge regulation changes in the U.S. in the coming years, too.
Zubin Ramdarshan: Creating standardization in ESG criteria becomes more challenging as the complexity increases. Will there be some market-driven consensus, or will the index providers be forced to align on a standard approach? I don’t know. But I don’t think standardization is a good ultimate goal. You want room for innovation and creativity given ESG is still so new. Creating a menu of choices is a better goal. We want to give our members and customers the choice of two or three different flavors of ESG, to address as many audiences as possible.
Where do you stand on the active versus passive management debate going on in the ESG space?
Zubin Ramdarshan: We don’t take a stance, but we recognize the trend is moving to passive asset management in general. So we want to offer a menu of products that the active or passive community can utilize. And the tilt toward passive naturally lends itself towards indexing, which plays to our strengths with a strong index derivative suite that’s already comprised of 18 index futures and four index options. We’re well positioned for the move toward passive.
Rebecca Chesworth: I see the trend toward index investment continuing but, within ETFs I also see innovation in active ESG growing. More money will go into ESG investing via ETFs because that trend is unstoppable now.
One of the biggest changes over the last 10 years is the realization that you can have ESG in index form. At first investors only thought of it in active terms, but large passive houses stood up and index providers created innovative solutions. Now, index providers and fund managers must convince investors that we can do the job of asset stewardship just as well as active managers.
Are we moving away from investors wanting ESG as core beta exposure and toward it becoming more thematic? Where is the ideal thematic and ESG intersection?
Zubin Ramdarshan: The word “thematic” suggests that themes come in and out of vogue, but I see ESG as a core part of portfolios now and a long-term structural pattern. That said, there is definitely an intersection between themes and ESG. If you look into the E, S and G separately, you get into themes such as water scarcity, female participation in the labor force, diversity, green real estate, and many others.
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 have greater prominence at different periods. For example, everyone wants to talk about climate now, but in mid 2020 it looked like social themes might take dominance. I see ESG becoming a natural layer on top of the core beta investing, and we will see themes that may become more important than, say, looking at aspects such as value and growth, or styles.
Above everything, it is important to remember that ESG is triggering real changes. In 2016, State Street Global Advisors launched a gender fund in the U.S., comprising companies that have women on their board. The associated Fearless Girl campaign demanded action and many companies responded by appointing women to their board. In 2017, our Fearless Girl statue at Wall Street became a symbol of gender equality in the workplace. It is clear that ESG efforts do make a real-world difference.