Discovering the good and the bad among responsible etfs

Just over a year ago I started what I thought was a simple idea, to put together some low-cost responsible investment portfolios, readily available online for anyone to invest in. As my focus was low-cost, I thought the best products would come from the wide range of responsible exchange-traded funds (ETFs). By my reckoning there are close to 100 such ETFs globally to choose from, more than enough to construct some well-diversified investment portfolios.

What I discovered in this search is that there are, on the one hand, some great, innovative products available. On the other hand, there are some that are responsible investments in name only. For me, the due diligence process was a lot more interesting than I expected, and I have shared some of my insights below.

Highlights of the good points

Let’s start with the good stuff. In recent years there’s been a large increase in the range of responsible ETFs on offer. Of the ones we reviewed, over 25% were created in the past year. This has led to the launch of some innovative products, enabling investors to tailor their portfolios to their unique values. These include:

• UN sustainable development goals: In September 2015 the United Nations set out 17 goals designed to transform the world. These include eradication of poverty, quality education, gender equality, clean energy, and many more. Blackrock have put together an ETF (ticker MPCT:NAS) where investors can access companies that generated at least 50% of their revenue from achieving one of these goals.
• Gender diversity: A number of studies have shown that companies with more women on the board perform better than their male-dominated counterparts. If you want to support gender diversity, State Street Global Advisors offer an ETF (ticker SHE:NYS) that invests in S&P 500 companies based on the number of women on the board and in senior leadership positions.
• Organic food: If you love your organic produce and want to align your investments with your eating habits, you could try Janus Capital’s ETF (ticker ORG). This ETF invests in global companies that service, produce, distribute or sell organic food, drinks, and cosmetics.
• LGBT rights: Workplace equality is a broader issue than just gender diversity. Denver Investments offers an ETF (ticker EQLT:NYS) that invests in US companies that support LGBT equality in the workplace, for example by offering benefits to same-sex couples.

Above is just a sample of some of the ETFs we came across that offer something more than just negative screens. There are also a wide range of ETFs available that do offer the negative screens, excluding tobacco, gambling, alcohol, pornography, and arms-related enterprises.

Some questionable ETFs

‘Responsible Investment’ is a widely-used term, open to interpretation by whomever is constructing the ETF, and this project has taught me that there are uncertainties when selecting a responsible ETF investment.

Definitional differences

Index providers use their own definitions that are not consistent among providers. Some examples include:

• Environmental, Social & Governance (ESG) criteria: One ESG ETF is not necessarily the same as another, it depends on the index provider’s ESG criteria. Even those that rely on the same criteria, such as a MSCI ESG rating, may apply it differently. For example, some ETFs only invest in companies with a minimum MSCI ESG Rating, others consider the rating but do not have a minimum threshold.
• Fossil fuel free: Fossil fuels are a particularly tricky area. Some indexes define a fossil fuel company as one that holds fossil fuel reserves, others only exclude those that produce ‘more carbon-intensive fossil fuels’, while others exclude companies with a ‘significant interest in’ fossil fuels. It is worth checking the fine print to make sure your fossil fuel free ETF is excluding the companies you want to divest from. 
• Emerging markets: Many index providers have a slightly different definition of emerging markets. If there are particular countries that you are looking to invest in, check that they are included in the definition.

Surprising inclusions

It is always worth looking at an ETF’s holdings if you’re considering an investment, and sometimes they may surprise you. For example:

• We came across a couple of ESG ETFs that include Wells Fargo. Apparently they have a very high ESG Score, however many people would expect the large-scale fraud that occurred at the bank to automatically exclude them from an ESG portfolio.
• The iShares MSCI Low Carbon Target Index has a 73% reduction in current carbon emission intensity and a 99% reduction in potential carbon emissions when compared to the MSCI All World Index. This is great, but it should not be confused with a fossil fuel free index as it does contain some oil companies (e.g. Exxon Mobil, Chevron, Caltex).
• An ETF that has a single focus (e.g. women on the board, or fossil fuel free) will invest purely based on that focus. Such an ETF could therefore contain companies involved in tobacco, gambling, or pornography. Don’t assume that because an ETF has a single ethical focus it excludes all non-ethical industries.

ASX-listed ETFs

• BetaShares: Although not included in the eBook (this ETF was launched after publication), it is worth mentioning the recently launched BetaShares Global Sustainability Leaders ETF (ETHI).  The ETF offers exposure to 100 international companies that are “Climate Leaders” (based on carbon efficiency).  It also excludes those companies with material exposure to fossil fuels, gambling, tobacco, pornography, uranium, junk food, animal cruelty and a number of other “irresponsible”  industries.  If you are happy with the criteria, this ETF could provide a good way to get exposure to an international portfolio of ethical companies, all via the ASX.
• UBS:  offers six ETFs with exposure to different regions, all of which exclude tobacco and controversial weapons (i.e. landmines, cluster bombs, chemical weapons). Yet two of these do not exclude any companies. In Australia, there are no tobacco or controversial weapons companies in the ASX100, so the UBS ETF is exactly the same as a mainstream investment. Similarly, in their Asia APEX 50 Ethical ETF (UBP:ASX), there are no tobacco or controversial weapons in the top 50 largest companies in Asia, so essentially you are investing in the MSCI Asia Apex 50.

There is nothing inherently wrong with these ETFs, they do follow the guidelines and none of the ETFs include tobacco or controversial weapons. However, while the product is true to the stated exclusions, they are somewhat redundant.

• Russell Investments:   Russell Investments have the Russell Australian Responsible Investment ETF.  It offers a portfolio of high dividend paying Australian shares, investing only in ESG companies.  The ETF excludes tobacco, alcohol, gambling, pornography, armaments and the production of more carbon intensive fossil fuels.  It should be noted that this is not a fossil-fuel free ETF, the portfolio does contain companies such as Woodside Petroleum. 

Final thoughts

Responsible Investing is a broadly used term, encompassing a wide spectrum that stretches from very basic negative screens (e.g. no tobacco or gambling) to very specific positive inclusions (e.g. organic food).  Prior to choosing an ETF it is important to consider:

Returns:  One of the most common concerns about responsible investing is that it involves lower than market returns.  In fact, this is not the case.  The Responsible Investment Association of Australasia’s data shows that responsible investments often outperform more mainstream investments.   

You should not necessarily expect lower returns while investing responsibly, but like any good investment strategy, you should consider the expected returns of your ETF, and make sure it is part of a diversified portfolio.  For example, many of the clean-tech and clean energy ETFs have performed terribly since inception, if you only invested in this one industry, your portfolio would have suffered.   Make sure you do not sacrifice returns by overly concentrating your ethical focus.

Funds under management (FUM):  Currently, Responsible Investing is still a small part of the total investment universe.  As such, some responsible ETFs have low funds under management (i.e. less than $10 million), this creates the risk that your ETF may be wound-up, particularly if you are investing via a smaller manager.  Investing in a larger ETF (FUM > $100 million) will reduce the risk of your ETF being wound-up.  

Fine Print:  Read the fine print, this includes the fund documentation, which will set out exactly how the individual investments are selected and the screens are applied.  It is also worth downloading the current holdings, to make sure that the portfolio doesn’t include any surprises.

Responsible investment has experienced growth in recent years, including an increase in the amount of responsible funds and ETFs on offer.  However, like all parts of the fund management universe, there is  a wide variation in the quality and credentials of the fund management and criteria.  Do you due diligence to make sure you are getting what you paid for. 

Content first published on cuffelinks.com.au. A full list of ethical ETFs that were reviewed can be found in the ebook at www.balanceimpact.com.au/ebook