Responsible Investing: From ESG integration to net zero with ETFs and indexed strategies

Asian Investor previously reported that global ETF flows crossed $1T USD in 2021 with ESG ETFs garnering most interest.¹ Indeed, part of the growth in ETFs stem from the attractiveness of this investment vehicle, notably its cost competitiveness, liquidity, and accessibility. Coupled with broader responsibility investing trends, we believe there is significant opportunity in ESG investing with indexed strategies 

Indexed strategies catering to the broad ESG spectrum

At Invesco, we like to see ESG investing as a spectrum of different investment approaches. In an earlier paper The real deal: Misconceptions of ESG ETF investing we highlighted the ability of ETFs to align to investor goals based on preferences in tracking error against that of ESG exposure and targeting. This in turn translates to a range of ESG strategies that investors can consider, from basic exclusions (removing issuers with higher ESG risks) to overweighting or tilting towards better ESG performers, to targeting specific ESG thematics and impact strategies. This is also in line with global trends in responsible investing. While historically ESG strategies have focused on two extremes (ethical exclusions and best-in-class), there has been a proliferation of wider approaches in recent years. For example, increasing ESG regulatory developments such as the SFDR (Sustainable Finance Disclosure Regulation) in the EU help to drive systematic ESG integration and also greater investor appetite for combining exclusions with tilting. The global climate agenda on the other hand creates investment opportunities in specific climate themes. Taking an ETF approach allows for targeted exposure to different ESG strategies depending on what an investor’s objectives and needs are.  

Factoring in ESG risks through exclusions and tilts 

A broad-based ESG integrated approach allows investors to capture value from ESG risk considerations either by excluding higher risk issuers or sectors or tilting towards better performing ESG leaders. For example, the focus on modern slavery legislation in Australia has increased investor scrutiny on supply chain risks of companies and potential liabilities to fines. Other ESG risks include climate transition and physical risks such as stranded assets liabilities. On the flipside, deploying a positive tilt strategy enables an investment thesis towards companies capturing changing consumer preferences and industry trends towards sustainability while also benefitting from broader investor activity in ESG space. Government policies and regulations such as mandatory ESG or climate disclosures will also shift more capital allocation to ESG investing, further benefitting companies positioned as ESG leaders.  

Climate and sustainability investment opportunities 

Global progress on climate transition has also translated to thematic opportunities. Whether it is policies relating to phasing out coal or promoting electric vehicles (EVs) or developments in Asia such as China and India’s net zero commitments including detailed decarbonization plans, climate themes will continue to be a focus. Investment themes include climate solutions such as renewables (wind, solar or EVs for example) and climate transition leaders in heavy-emitting sectors who have made substantial efforts to decarbonize. There is also a broader net zero opportunity to actively consider carbon reduction alignment in investment considerations driven by EU developments such as Paris-aligned benchmarks and indexes designed to meet scientific emissions reduction targets and temperature alignment timelines. Some indexes also account for carbon transition scores of companies to capture transition risks. Apart from climate transition, interest in biodiversity has been growing rapidly with the upcoming launch of the TNFD (Taskforce for Nature Related Financial Disclosures) expected in 2022 along with developments in deforestation pledges at COP26. Natural capital will be a theme to watch with potential opportunities in thematics like water and sustainable agriculture and food. 

Investing in ESG ETFs?  

Overall indexed strategies can allow for customization of ESG preferences to tailored investment strategies. Incorporating ESG considerations is often correlated to quality bias that is a long-term driver of outperformance. With flows going across the spectrum whether to exclusionary, tilting, or thematic strategies, we believe that investors can pick a strategy most suited to their ESG requirements alongside considerations of tracking error and sector diversification. Understanding the underlying ESG investment approach and objectives and evaluating against actual strategy implementation also helps investors address potential greenwashing risks. ESG ETFs are a fast-growing investment segment and an interesting one for investors to keep a look out on. 

Investment risks 

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.