ESG ETFs: Understanding the different approaches

Strong demand for passive ESG investments has led to the launch of more than 500 ESG ETFs over the past decade. More than $310 billion of assets are currently invested in ETFs classified by their issuers as ESG¹. But with so many funds now available in Europe, how can investors find the ones most suitable to them? Here, we will explore and help define the broad range of ESG approaches, including both what they aim to do … and what they don’t aim to do.

Breaking down the jargon

This broad term “ESG” refers to a wide range of funds that consider environmental, social and corporate governance issues as part of their security selection and allocation methodology. The basic concept is nothing new; some active funds have been picking stocks and shunning others based on ethical interpretations for over a century. The more recent development has been in passive ETFs that follow ESG indices based on specific rules rather than an individual’s decision-making.

An ESG index is normally derived from a standard market-cap weighted index (the parent index). For example, the MSCI USA ESG Universal Select Business Screens Index and the MSCI USA ESG Climate Paris Aligned Benchmark Select Index are both derivations of the parent MSCI USA Index. These two ESG indices are constructed from the exact same universe of stocks but are substantially different from each other due to the approaches they take.  

Index providers such as MSCI and S&P will generally use ESG ratings (or scores) to select and weight securities. These ratings are provided either by an external company specialising in ESG research and analysis, or internally if the index house has the necessary resource and expertise. 

Based on the amount of assets held, ETFs that follow a strict “best in class” approach are the largest part of the ESG ETF market. However, in 2022 and so far in 2023, “climate” ETFs have gathered the most assets. As we look at each of the different approaches available, we will focus on the underlying indices being followed, as most ESG ETFs are passively managed.

Different approaches, different objectives

The first stage of constructing any ESG index will be to remove any securities of companies involved in what the index provider has defined as controversial activities or industries, normally including the likes of controversial weapons, coal and tobacco. Some indices will have a short list of business exclusions while others will have a longer list, so investors should check what is being removed from the index at this stage of the process. As a general rule, the more securities that are removed, the more the ESG index performance is likely to deviate from that of the parent index. 

Indices adopting an Exclusions approach typically follow a two-step process:

1. Remove any securities from the parent index based on a business activity criteria,  
2. Reweight the remaining securities (usually by their market capitalisation).

The intention of an Exclusions approach is generally to construct an index profile similar to that of the parent index but without any securities considered completely unacceptable, as defined by the index provider in the index methodology. This type of approach will almost certainly lead to an index that includes securities with low ESG scores or that are involved in business activities that may be excluded by stricter ESG approaches.

An Exclusions approach also won’t include any “positive” screens, such as amplifying the weight of companies that may have a higher ESG score or that are generating more green revenue. ETFs that follow an Exclusions-based index may sometimes be referred to as taking a “lighter-touch” ESG approach.    

Indices adopting a Tilting approach will also aim to provide similar characteristics as the parent index but with a methodology intended to improve the overall ESG score or other relevant metrics such as, for example, lowering carbon intensity or increasing green revenues compared to the parent index. As mentioned, the first step in the approach taken by these indices will often be the same as for Exclusions:

1. Remove any securities from the parent index based on business activity criteria,
2. Apply a tilting factor to remaining securities based on ESG scores (usually relative to peers)
   1. Increase weight of those with above-average scores
   2. Reduce weight of those with below-average scores

The index methodology will define the targets and explain the mechanics of the tilting, but in general will increase the weight of certain securities and reduce the weight of others. The Tilting approach effectively rewards companies that are producing favourable ESG results and punishing those lagging behind (still having exposure to these laggards but at reduced weighting).   

Indices adopting a Best-in-class approach are typically designed to focus on the companies exhibiting the highest ESG characteristics within their sectors, while totally excluding the lowest ESG performers. Again, the approach typically begins with exclusions:

1. Remove any securities from the parent index based on business activity criteria,
2. Remove all securities below a predefined threshold based on ESG score,
3. Reweight remaining securities according to index methodology, which may involve optimisation or some other techniques with the aim of reducing tracking error.

The performance of these indices could normally be expected to deviate more from their parent index than other ESG approaches, depending on how many constituents are removed. The “lightest” best-in-class approaches may aim to capture around 75% of the parent index whereas the “strictest” versions could aim to capture only the top 25% of the market weight, selected based on ESG scores. The stricter the selection criteria, the more its performance is likely to deviate from the parent index.

Indices categorised as having a Climate objective will generally adhere to the principles behind the EU’s regulatory framework for climate-related investment funds. Most of these will be Paris-aligned benchmarks (PABs) while a smaller number will be Climate-transition benchmarks (CTBs). The European Commission established these benchmarks to provide investors with increased transparency into how indices that carry these designations plan on achieving their objectives related to greenhouse gas (GHG) emissions and the transition to a lower carbon economy.

• PAB indices are designed to meet the long-term goals of the Paris Agreement on climate change. A PAB index must have at least a 50% reduction in greenhouse gas (GHG) emissions compared to its parent index and also meet a 7% year-on-year reduction.   
• CTB indices are generally considered to be less strict than PAB indices. For instance, a CTB index has different thresholds, such as a 30% minimum reduction in GHG emissions compared to its parent index (less than the PAB minimum of 50%).

Thematic indices are the final category, these strategies differ as they’re more likely to be concentrated on a narrow part of the market rather than offering broad exposure. Examples are clean energy or other environmental-focused indices. A thematic index will typically aim to capture those companies that are contributing to or benefiting from a powerful, long-term trend. Some indices may contain a small number of securities while others will be more diversified. How an index is constructed may also be worth considering. For example, an index can weight the constituents by market capitalisation, thematic exposure or spread exposure evenly (equal weighting).

Conclusion

Hopefully, this has provided you with a better understanding of the different approaches taken by the indices an ESG ETF may aim to follow. No approach is “better” or “worse” as they each aim to fulfil different objectives. The most important consideration for investors is which approach meets their own objectives, both in terms of ESG and financial performance. The next step is to find an ETF that can deliver that index performance as cost effectively as possible.