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