3 etfs to capitalise on the ethical-investing boom

For years, ethical investing was perceived as a trade-off. Investors sacrificed some return and paid higher fees to ensure they invested in sustainable companies and sectors.

Some new exchange traded funds (ETFs) have made it easier and cheaper to invest ethically, as research shows rising interest in sustainable investing. Ethical investing is now as much about making money and minimising risk as it is about doing the right thing.

Powerful trends are driving growth in ethical investing. Young investors want to own shares in companies and sectors that do not harm people and will act to do so.

9 in 10 Australians expect their superannuation to be invested responsibly and ethically, shows a survey last year by Responsible Investment Association Australasia (RIAA). Just over half of respondents will consider making ethical or responsible investments in the next one to five years – an incredible finding if it holds true for the broader investing population.

RIAA’s recent Super Fund Responsible Benchmark Report found 81% of Australia’s largest super funds are committed to responsible investment, up from 70% in 2016. RIAA said super funds are ramping up their engagement in responsible investing to drive outperformance, minimise risk and meet member expectations.

Responsible versus ethical investing

Responsible investing by super funds is not the same as ethical investing. Super funds that adhere to United Nations Principles of Responsible Investment incorporate Environmental, Social and Governance (ESG) data on companies as part of their investment process.

They might, for example, screen companies for ESG performance on climate-change disclosures, gender diversity, occupational health and safety performance and staff turnover. Increasingly, there is more focus on non-financial data in investment decisions by institutions.

Ethical investing, on the other hand, excludes sectors considered to be harmful, such as alcohol and tobacco, weapons, coal, uranium, intensive farming and aquaculture, and forestry (deforestation). In contrast, a fund that incorporates ESG data might have limited sector exclusions. Many Australian super funds exclude investments in tobacco and weapons, for example.

Assets under management through ethical investing are booming. Core responsible investment, which includes ethical investing, had $64.9 billion of assets under management in December 2016, up 26% on a year earlier, RIAA data shows.

If the industry doubles within five years – not unreasonable given recent growth rates – another $50 billion or so could flow into ethical funds over that period.

As money flows into ethical funds, more managers will issue active ethical funds (listed or unlisted funds or trusts) or passive exchange traded funds (ETFs) that replicate ethical share market indices. As competition intensifies, higher fees for ethical funds, which require extra screening by fund managers and thus charge more, will reduce.

I suspect there will be a blurring of ethical investing (core) and ESG investing (broad styles). More ESG funds will exclude a wider range of harmful sectors (Australian funds excluding tobacco and weapons is largely meaningless, given we have few such listed companies).

Meanwhile, ethical funds will take a tougher stance on ESG issues in companies. Australian Ethical’s decision in May to divest AMP from its portfolio, after the Financial Services Royal Commission exposed scandals at the wealth manager, is a case in point.

As ethical funds expand, investors should look to make money from this trend by investing in issuers of ethical products or the funds themselves.

3 ETF newcomers

ETFs are an interesting newcomer in ethical investing in Australia. Ethical investing is typically thought of as something for active managers because it requires specialist skills to screen companies and sectors considered to be harmful.

But ethical funds are generally considered more expensive. High fees have been a sticking point in the past for investing in ethical funds. Like other ETFs, ethical or sustainable ETFs come with much lower fees, but only provide a market return.

The ETF boom in Australia and overseas shows many investors are content to receive similar yield and capital growth to an underlying index, if it means lower fees and instant portfolio diversification, by being able to buy and sell ETFs like shares on the ASX. The message that the majority of active mangers underperform their index over time is getting through.

Several ethical ETF options exist. The first is five international equity ETFs with an ethical overlay from UBS. The ETFs cover Australia, Europe, Japan, Asia and the United States and exclude tobacco and controversial weapons companies – limited screening by ethical fund standards.

The UBS ETFs may not appeal to investors who have tougher ethical-investing criteria, notably those who demand the exclusion of fossil fuel companies from portfolios. Annual fees range from 20 basis points for the US ETF, to 45 basis points for the Asian ETF. The UBS funds are small by ETF standards.

The BetaShares Australian Sustainability Leaders ETF (FAIR) is an interesting idea. Launched in November 2017, FAIR owns stocks that pass eligibility screens that exclude companies with direct exposure to fossil fuels or other operations that are inconsistent with responsible investing principles.

Just over a quarter of FAIR is invested in healthcare stocks and around 20% in financial services and real estate. Materials (mining) constitutes less than 4% of the ETF. FAIR has returned 3.5% in seven months, broadly in line with its underlying index. Annual management costs are 49 basis points.

Chart 1: BetaShares Australian Sustainability Leaders ETF (FAIR:ASX)

Source: nabtrade

The BetaShares Global Sustainability Leaders ETF (ETHI) has a similar approach. The ETF provides exposure to 100 large global stocks that are climate-change leaders and rate well on responsible investment considerations.

The ETF is weighted towards US equities and about a third of stocks in its index are information technology companies. The ETF returned 13.7% over one year to May 2018. The annual fee is 59 basis points.

Chart 2: BetaShares Global Sustainability Leaders ETF (ETHI:ASX)

Source: nabtrade

The VanEck Vectors MSCI International Sustainable Equity ETF (ESGI) is another innovative newcomer. ESGI excludes fossil-fuel companies, high carbon emitters and those whose activities are not socially responsible. The ETF includes companies with high ESG ratings.

It’s a clever ETF. By excluding harmful sectors and weighting the index towards companies with high ESG ratings, the ETF provides aspects of ethical (core) and responsible (broad) investing – a blurring of styles alluded to earlier.

The ETF owns several software and healthcare companies and three quarters of its portfolio is invested in the US. ESGI has had a good start, up 4% since inception. The annual fee of 55 basis points is higher than rival ethical ETFs, but ESGI has additional screening.

Chart 3: VanEck Vectors MSCI International Sustainable Equity ETF (ESGI:ASX)

Source: nabtrade