ESG ETFs: A Trend or a Fad?
Frank [00:00:02] Hi, I'm Frank Koudelka, global head of ETF Solutions at State Street and I'm joined by Ciarán Fitzpatrick, head of ETF Solutions in Europe and co-author of our recently published research titled ‘Future Focused: Insights into Global ETF Trends’. We're conducting a series of podcasts with subject matter experts to take a deeper dive into the ETF megatrends we've been experiencing over the last several years. For this segment, we're joined by Phil Kim, global head of ESG Solutions at State Street. In our recent Future Focused paper, we discussed how ESG ETFs are becoming a larger component of ETF assets and inflows. The ESG ETF market had less than 50 billion in global assets five years ago and now enjoying over 400 billion last year, an annualized growth rate of close to 75 percent. Local regulators, investor appetite and product availability vary from market-to-market, so we'll spend some time detailing regional trends. So with that as a backdrop, let's get started. Thanks for joining us, Phil.
Phil [00:01:09] Good to be here and thanks for having me, Frank.
Frank [00:01:12] Let's start with the basics. What is ESG and is it an important investment trend or simply a fad that burns out during the next market cycle?
Phil [00:01:21] ESG stands for Environmental, Social and Governance and reflects how a company manages a wide spectrum of issues in each of these respective pillars, such as climate change, biodiversity, employee/customer/and supplier relations and management and board level compensation and structures. These factors can be incorporated into the investment decision-making process in a number of ways. One common approach is to avoid ESG risks is through exclusionary screens. Another is through deeper ESG integration and incorporating it into company valuation models. You can also identify and monitor material ESG risks to a portfolio from a top-down basis or through a more bottoms-up approach. Or you could even practice active ownership via company engagement and or proxy voting. I strongly do not believe ESG is a fad, as it will continue to transform the investment management industry in my view. The growth in the market for ESG products and services has been phenomenal, in large part due to client demand to essentially invest their assets in companies who are using the funds in a way that is aligned with their values and also fueled by broad recognition by certain issuers that ESG factors are material and therefore affect risk and return, especially over the long-term. Finally, regulations concerning ESG data, investments in products, and how asset owners and asset managers consider these things as part of their fiduciary duty are all now moving into effect and being enforced, which should drive both staying power and a greater need for subject matter expertise for both the regulations and ESG
Ciarán [00:03:12] Thanks for those initial insights, Phil. So Europe has been the leader in the adoption of ESG ETFs with close to 55 percent of 2021 flows going into ESG ETFs and slightly over 50 percent of 2022 to date. European Union's (EU) introduction of the Sustainable Finance Disclosure Regulation or SFDR for short has provided significant regulatory tailwind. Can you tell us about the regulation and why it should lead to even more growth for ESG ETFs into the future?
Phil [00:03:41] I really think, you know, the SFDR has been top of mind over the last year for many of our clients. And, you know, essentially SFDR requires all EU-domiciled funds and financial market participants with over 500 employees to disclose a series of ESG data points at the entity and product level, essentially in an effort to improve transparency for sustainable products, to essentially put the right label on the box. This should help then to, you know, increase adoption of sustainable investments, especially in the EU. So with these regulations, we're seeing many funds actually reclassify as either, "sustainable" Article 8 funds and then on the flip side, we're seeing many headlines that many of these actually don't qualify or don't have the necessary data for proper disclosure, and therefore, many funds are proactively classifying out of it. So if anything, I think, you know, it will help put some more trust in these ETFs that are classified as ESG or that have an ESG theme that actually meet the criteria. And ultimately, this will help provide, you know, the transparency to investors, which was ultimately the driving purpose of these regulations. And that, in turn, should help propel more demand and growth in all types of ESG funds in the future. And real quickly, aside from the regulations, I also believe that, again, investor demand is equally, if not more, of the driving force. Ultimately, funds want to market ESG characteristics as it attracts flows is a form of differentiation and again, many believe are part and parcel to risk and therefore the number of Article 8 and 9 ESG funds has steadily grown over the past year and account for over 50 percent of all EU funds. Despite recent pushback on ESG in specific areas, particularly in the US, demand for ESG remains strong, and many asset managers globally are incorporating ESG in some fashion, which could, out of necessity, be a point of emphasis to stay marketable, to help with reputation risk around potential greenwashing. But also because of going back to the earlier point, investors want to align their investments with critical ESG criteria to achieve long-term returns and their hope and vision for a sustainable future. And many investors essentially want to preserve the things they value.
Ciarán [00:06:13] Thanks, Phil, so with the potential tailwinds we've seen, there's also been some concerns regarding greenwashing, as you've just mentioned above. So can you tell us what greenwashing is and how the regulators or investors are dealing with the problem?
Phil [00:06:24] Yes, so greenwashing is essentially misstating or overstating the objective of what are branded as ESG investment products by actively or inadvertently misleading investors and how ESG factors are considered in their investment decision-making process. So, for example, you know, marketing your fund as a, you know, low-carbon fund, but not truly having the tools and frameworks in place to ensure that the fund is either avoiding heavy carbon emitting firms or mitigating the emissions from those firms in some way, such as through management engagement or proxies, as we discussed earlier. Therefore, you know, this could potentially result in having high emitters in the portfolio. Not only is this misleading to investors, but it puts them at risk if they do not want to be invested in high carbon emitters for the long-term because they believe these companies will see lower valuations in the future. Concerns about greenwashing are, you know, I think is what is ultimately driving the regulators to put in place these rules to help protect investors from putting their money somewhere that is in doing what they say. So following the EU, you know, here in the US, the SEC and several other jurisdictions are proposing to include ESG characteristics into ongoing disclosure requirements. So for example, the SEC's revision to the names rule and the new ESG proposal rule would require funds making claims about their use of ESG factors to provide clients with enhanced disclosures on how they do so. SEC Chair Gary Gensler, I think he put it really nicely, essentially stating that it's like a nutrition label. You want to be able to know the ingredients underlying these funds. So for investors, it's really going to be important to have the right systems and solutions in place to adequately and comprehensively meet these regulatory requirements and to be able to understand, you know, essentially where your investments stand across your investment lifecycle so you can take mitigating action if needed. The same sentiment goes for ESG risk management. Firms will need strong regulatory reporting and investment risk controls in place to help ensure, "regulatory and investment compliance" in order to prevent the accusation of greenwashing. To get started, you know, one simple thing clients can do is monitor their portfolios, the ESG metrics along with their portfolios, or by using ESG post-trade compliance alerts, you know, you can easily set your thresholds and get notified when your exposure is approaching or breaching certain thresholds. And, you know, I think, we sometimes overthink it and by taking simple measures like this and building on it, I think we can avoid firms can, you know, essentially avoid bigger issues over time.
Frank [00:09:12] Thanks, Phil that's a great summary and you did mention the US regulatory market. So let's turn to the US ESG ETF market. 2020 and 2021 saw a large increase of inflows and assets under management. And although issuers and new ESG ETFs continue to expand, flows have been reduced by over 60 percent in 2022. Is this more a result of the economic downturn that we've seen, or is there something exacerbating the ESG slowdown?
Phil [00:09:42] I think the market downturn is the main driver here, but we certainly know in the US, ESG is fragmented. So I wouldn't be surprised if we continue to see things being bumpy in the next few years in terms of seeing even more ESG backlash. At the same time, however, I do think that ESG has been resilient, at least from what I've seen in the last 10 years. You know, there have been several bumps in the road along the way in the past. And yet, ESG flows over that 10-year period has overall just continued to grow and grow. So as much as it's fragmented here in the US, there's still very clear interest in ESG investing as a long-term driver and the driver of long-term value. And, you know, frankly, I think it's our job at State Street to help clients, you know, along the way, whether they want to incorporate ESG or not.
Frank [00:10:36] Thanks, Phil, so I like to take the contrarian view. And as I've watched the market gravitate towards new trends or what I call the shiny new toy during my career, I looked at this RBC Wealth Management survey that showed 49 percent of US-based clients say performance and returns are a higher priority than ESG impact. Shouldn't we all be solely looking at return on investment when making financial decisions? Why should we select the ESG S&P 500 if it will underperform the broader S&P 500?
Phil [00:11:11] Yes, I think that's a really great question. And I think it highlights a common misconception about ESG investing in that you have to expect to take a haircut in performance in order to invest sustainably. ESG S&P 500 ETF actually outperformed the traditional S&P 500 by over 150 basis points during the past three years. But ultimately, I really think it depends on what you're trying to measure. When we talk about returns, are we talking about, you know, over what duration? Are we talking about in the next quarter or a longer-term view? I think with the recent market downturn and current, you know, situations, you know, globally, especially with the Russia-Ukraine situation, it's easy for people to point the finger to ESG. And I think most of this commentary, frankly, comes from folks who don't incorporate ESG today and don't have any plans to. But overall, you know, we're seeing more and more investors who I think look at ESG over a longer-term horizon. You know, there have been a number of studies published by our internal research team and throughout the academic community dispelling this myth. Our own research team here at State Street, State Street Associates conducted a study showing that investing in the lowest carbon emitting firms in the energy sector produced a six percent return just over the past year, outperforming most traditional factors. And then finally, you know, setting aside the fact that until very recently that the SPYX has outperformed SPY over a most standard return time horizon, there's conversation to be had about what plan beneficiaries want their fiduciaries to do. Should they just ignore potentially material risk factors because they haven't historically been considered as part of the investment decision-making process? So, you know, ultimately, I think, yes, you know, return is important. You definitely should be looking at returns. But over, you know, your specific time horizon and risk tolerance level and it's really up to you if that means, you know, to ignore ESG factors or whether to consider them as a fiduciary. It's what you believe. Is the ESG part of helping achieve your fiduciary duty or not? You know, some of the discussion misses that. There's a lot of room for nuance by being an ESG investor, nobody is saying you should or have to divest in a particular sector like the energy sector, for example. ESG investing doesn't mean you have to divest in anything, really. You can still be an active investor in certain companies and be active in engagement and proxy voting. You can invest within sectors tilting to companies that align better with whichever ESG factors that you deem are material or important. So, you know, there are various ways to invest that are both ESG friendly that can generate a good return over the long-term and can ultimately lead to a more sustainable world for future generations as well.
Frank [00:14:17] Thanks, Phil, you had mentioned the regulatory environment earlier. So like SFDR in the European Union, the US Securities and Exchange Commission has proposed a pair of regulations that would potentially provide a lift to ESG investing. The first rule proposed in March would require public companies to disclose climate risks, and the second in May would standardize disclosures required from ESG funds and would also govern fund names. And then this follows that the Department of Labor (DOL) recently passed a rule that would expand companies’ ability to consider ESG factors in selecting investments for their retirement plans. Are these likely to be implemented, and are they good for ESG investment vehicles?
Phil [00:15:01] Yes, so we've been, you know, continuously monitoring these regulations that you mentioned, Frank. You know, I think the comment periods for both regulations closed over the summer and now the SECC has entered a quiet period where they will work to finalize the regulations over the coming months. We've also just recently seen the DOL implement a new rule that should come into effect in about 60 days that clarifies that retirement plan fiduciaries can take ESG into account when selecting 401k investments and exercise proxy voting where, you know, under the previous administration they were not allowed due to fiduciary responsibility concerns. So our team is, you know, actively engaged with regulators and we've been counseling clients to begin their preparations now because we do think it's coming. We believe these developments will help to address a number of issues that have been inhibiting ESG adoption from data availability issues to the standardization and comparability of ESG metrics. We also feel that, you know, enhanced transparency and accountability that these regulations will introduce into the marketplace will again only help accelerate the adoption of ESG strategies by asset owners and asset managers like SFDR. So following the EU's lead here and actually, you know, maybe potentially an enhancement or an improvement over, you know, kind of the sequencing of SFDR is that here in the US, ideally the company-based disclosure is happening first or at least around the same time before fund level disclosures instead of the other way around. But ultimately, we'll see whether the final rules take into account the need for a kind of adequate implementation lead times such that investment fund disclosures tend to build off of these corporate disclosures sufficiently. As mentioned before, I think, it is 100 percent good for the market, adds transparency and accountability that puts the right nutrition label on the box. And as also stated before, you know, regulations create opportunities for investment, ESG investment funds by again creating more transparency and trust that funds are doing what they say they do and for more to essentially evolve towards doing the same.
Frank [00:17:23] Thanks, Phil, maybe let's shift region a little bit to the Asia Pacific region where ESG ETFs are much smaller, with only 25 billion in assets in aggregate today. So although we have seen flows increase in 2022, are there any regulatory changes implemented or proposed that could lead to continued growth in the broader region or any individual countries in particular that you've got your eyes on?
Phil [00:17:45] Yes, I think in APAC it's definitely fragmented and there's some regulations and proposals in place for, you know, areas like Hong Kong and Singapore where they're mandating that firms incorporate climate risk into their risk management process. Australia and New Zealand are also implementing climate-related regulations and most of all these regulations are primarily anchored around, you know, alignment to the Task Force of Climate Related Disclosures, the TCFD framework, which is also required in the UK for FCA-regulated pension plans. So at State Street we've again staying on top of all these regulations and ultimately as TCFD is kind of the foundation to all this, we built a TCFD solution kind of on the back of our existing SFDR reporting solution and with our regulatory team here and keeping a close eye on again all these developments, we're really looking to help our clients get in front of these regulations as we expect TCFD style disclosures to continue to gain traction given the developments, you know, globally and in other areas of standard settings, such as with the ISSB, the International Sustainability Standards Board, which is also aligned to the TCFD framework.
Ciarán [00:19:08] Follow up on that field, are there any tools that State Street offers its ETF or mutual fund clients that support their ESG ambitions?
Phil [00:19:15] Yes, absolutely, you know, I like to think of State Street as an ESG solution provider. You know, where we can help provide access to multiple industry leading ESG data sets and help to provide services to help our clients incorporate ESG into their investment lifecycle. So we effectively can help with the cumbersome task of, you know, ESG regulatory compliance, data management, risk management and reporting while providing a significant cost and time savings versus in-house builds. We also don't just, you know, throw data over the wall, but have developed a team of subject matter experts and solution experts, who aid our clients with their ESG implementations. And so with the combination of data, technology and analytics and our subject matter experts, I believe it will help make ESG more accessible and easier for asset managers and asset owners, who want to get more involved and more sophisticated in their ESG investing and that's ultimately our goal here. As an ESG solutions provider, we aim to help service our clients who want to incorporate ESG into their investment lifecycle and make it easy for them. You know, ESG regulation is a first for many. So given our expansive team of ESG experts here, our involvement with the regulatory bodies and working groups and ultimately the vast experience we have at State Street helping our large client base with various regulatory requirements outside of ESG, we want to be there for our clients to help facilitate however they want to approach ESG.
Frank [00:20:55] Well, all right, this was a great conversation. Thank you for your perspective, Phil, they were really spot on. You took us through a global view of ESG and how it impacts the ETF marketplace, which is very important as an investment wrapper. Thank you all for taking the time to listen to this podcast. Please stay tuned for our next on the ETF market and check out our ETF servicing web page on statestreet.com for more insights. Take care and have a great day.
Five years ago, the ESG ETF market had less than US$50 billion* in global assets.
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