Sustainable Investments: A Guide For Young Generations. Article 6 - Sustainability Indexes and ETFs

Active and Passive Mutual Funds

Since their inception, mutual funds have always been a favorite investment vehicle for investors that want to leave their investment decisions on the hand of professionals. They pool together sums of money collected by many individual investors or professional ones and then invest it in different security types. Different mutual funds exist, but the most important distinction is made according to the involvement that the professionals have on managing their clients’ money. The most important categories are:

• “Actively managed funds”, in which the institutional investors are actively involved in finding the best securities to invest, by getting in return management and performance fees, based on how much profit did they made for their clients, and

• “Passive investment funds”, which are those vehicles that mimic the performance of a market index, where the role of the fund’s manager is not creating the fund’s strategy and the stock picking, but copying the movements of a certain index on which the fund is based. Since the involvement of the institutional investors here is very basic, the fees that the money managers get in return are very low.

As can be understood, market indexes play a fundamental role in the investment industry. They are hypothetical portfolios made of securities that represent a segment of the financial market (global, regional, or local), aiming to give interested investors insights regarding market movements and initial investable universes. But the most important role that market indexes have is that of being considered as benchmarks from active managed funds, while on the same time being considered as the base for developing passive funds. For example, the S&P 500, which is considered to be the most popular stock market index, represents the segment of the US Financial Market that is made from the largest 500 public companies. Numerous active funds want to outperform the returns of the S&P 500, which they consider as their benchmark, while a lot of passive funds just buy for their clients the companies that are included in the index, in order to achieve the index’s returns.

Starting from the aftermath of the 2008 financial crisis, passive investment funds are increasing in popularity among different types of players in the market, since investors are recognizing that the low costs, combined with the average market returns that these investments offer, very often result in a better alternative than investing in actively managed mutual funds, which only in 23% performed better than the average of their passive peers in the 10-year period ending in June 2019. The trend holds true also in the case of sustainable investments. Index-based funds that consider ESG criteria in their securities’ selection have grown with a rapid pace in both number of funds and in terms of assets that these funds manage. Data from the US shows that in 2018, active ESG funds had net outflows of $73 million while passive funds had net inflows of $5.4 billion, with 2019 experiencing a similar situation, where passive ESG funds attracted $4 billion more than their active peers (see image below). Since passive funds have market indexes in their backbones, this furious growth could not have been possible without the development and the recognition of ESG indexes.

Indexes in Sustainable Investments

The financial industry is always ready to come up with new solutions, providing investors with a lot of tools that can be embraced to make better informed decisions. When sustainable investments started getting traction in the late 20th century, the first index tracing companies that were considered sustainable according to ESG criteria (although at the time were not called ESG) was created. Founded in 1990, Domini 400 Social Index (now MSCI KLD 400 Social Index) includes 400 large-cap US based companies that have exemplary past records and admirable future plans regarding ESG factors. During the 30 years that followed since the index was launched, sustainable investments were taken in consideration by more and more individuals, and simple calculations suggest that more than 5.000 other ESG indexes are created and launched by different providers such as MSCI, Morningstar, S&P Dow Jones Indices and others. The sustainable indexes created from the same provider differ from one-another as for the sustainable strategy that they follow, for the asset classes that they cover, for the regions where they are focused, and for companies’ market caps, among other criteria. Meanwhile, index providers differ amongst them as for what type of data points they collect when assessing companies from the ESG standpoint, and as for the methodology that they use when creating the indexes, which may result in different providers creating sustainability indexes that cover the same strategy, region and market-cap, but that have different companies included. Therefore, investors should pay attention to choose a provider that measures sustainability commitments according to the way that they best see fit.

Like traditional indexes, sustainability indexes can be used for different purposes too. For investors that want to actively follow sustainable strategies by themselves, the total of the individual securities included in the indexes can be used as an initial investable universe, which is already filtered according to the approach that the index is prepared, making the process more efficient than choosing traditional indexes as investment universes. Investors can then apply further thresholds and/or other strategies to arrive at an optimal investment portfolio. Another way that the indexes can be used are in the case of active mutual funds, where managers can use the indexes by considering them as benchmarks to compare their funds’ financial performance, representing a more accurate comparison method. As for passive approaches, institutional investors can create sustainable index funds or sustainable ETFs that mimic the indexes’ performance, and then offer them to retail investors, which can gain access in sustainable investments in a cheap and efficient way. In addition, a less common indirect benefit of the sustainability indexes is also the boost that companies get when involved or not in these indexes: companies involved are more motivated to maintain their high ESG scores in order to not lose the place in the list, while also promoting their sustainability commitments to their stakeholders; on the other hand, companies that are not involved will see this as a challenge, and hopefully increase their commitments in order to make it to the list.

Exchange Traded Funds (ETFs): What are they?

Exchange Traded Funds are investment vehicles that contain a basket of securities and trade on an investment exchange. From the description it may not sound that much exciting, but ETFs combine the advantages of mutual fund with those of single stocks, becoming very attractive for both institutional and retail investors throughout the years. As a mutual fund, it offers diversification since it invests in a basket of securities. Moreover, ETFs can follow an active approach, where the manager and the investment team create the investment strategy and handpick the securities to be included in the basket, or they can function as a passive strategy, where they can track indexes, invest in special themes or sectors, and more. On the other hand, an ETF trades on an investment exchange just like a normal individual stock, having a price that fluctuates throughout the day as dictated by the demand and supply, making it possible for investors to enter or exit the investment in a matter of seconds, completely contrary to mutual funds where investors need to pass some bureaucratic steps in order to invest and exit, with trades happening only once a day, when the market closes. Another very important benefit that ETFs offer are the lower management fees compared to both active and passive mutual funds, since in contrary to them, ETFs do not have to redeem or issue new shares when investors want to exit or enter the fund, resulting in less operations to be executed, which itself results in fewer costs. Exchange Traded Funds invest according to different strategies and asset types, such as stocks, bonds, currencies, commodities, and enjoy also an advantage that mutual funds do not have, that of short-selling (making a bet that the price will fall), made by the so-called Inverse ETFs. They can be accessed very easily through online brokerage accounts, just by typing the ticker symbol on the search engine on the broker’s website and opening a trade. All these advantages have made ETFs a favorite investment vehicle among investors, which explains the enormous compound annual growth rate of 24% per year, sustained for 17 years.

In 2020, there were approximately 7.602 ETFs globally (from 453 in 2005), with 320 of them being launched in 2020 alone. The growth trend is likely to continue in the future, since more and more investors are recognizing ETFs as convenient investment vehicles, due to their specific characteristics that were previously mentioned.

As an example, one of the most popular exchange traded funds is the SPDR S&P500 Trust, better known under the ticker SPY, which is a passive ETF aimed at tracking the S&P 500 index, made from the largest 500 US based companies. SPY can be very easily purchased on traditional brokers and online ones, just as an ordinary stock, and it comes with annual management fees of 0.095%, while it pays to its holders an annual dividend of approximately 1.55% (made of the weighted dividends of the companies included in the index).

Sustainable Exchange Traded Funds

Sustainable ETFs are the byproduct of two of the most important trends that financial markets are experiencing during the last decades, more specifically the shift towards passive investing and the rise of sustainable investments. The high transparency and accessibility of ETFs perfectly complement those promoted from the philosophy of sustainable investments. ETFs are considered ESG if they are explicitly labeled as so, or if they are labeled with a specific ESG-related theme such as clean energy and more. Sustainable ETFs have the same identic characteristics of normal ETFs, with the only difference being the investment philosophy on where the funds are going to be invested. This paragraph will be mainly based on the report issued by MSCI “Fund ESG Transparency”.

As the byproduct of two high-growing trends, ESG ETFs are following the same steps. They have recorded a substantial growth over the last years, with assets under management increasing 25-fold in only half a decade, reaching $150 billion in 2020 from $6 billion in 2015126. Net inflows alone amounted to 75 billion in 2020, more than doubling the total assets under management that were held until in sustainable ETFs until 2019.

USA represents the biggest financial market on earth, but when it comes to ESG ETFs, Europe takes the first place, accounting for 51% of the assets under management and the number of funds, compared to 39% of North American funds. The trend is in line with that of the total assets under management that are held according to sustainable investing, presented in the second article of the series. Despite the significant gap between the two continents, net inflows have been increasing faster in the USA in recent years, with expectations that the North American continent to reach at least the same levels as Europe in the upcoming years. In other parts of the globe, sustainable investing is still at an early phase, reflected by the low number of assets under management.

A table with the largest sustainable ETFs that can be accessed very easily through online brokers is showed in figure 40.

References:

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Matos, Pedro. ESG AND RESPONSIBLE INSTITUTIONAL INVESTING AROUND THE WORLD: A CRITICAL REVIEW. CFA Institute Research Foundation, 2020.

“The Rise of ESG in Passive Investments.” USSIF, 2020.

Fernando, Jason. “MSCI KLD 400 Social Index.” Investopedia, Dotdash, 3 Dec. 2020.

Chen, James.“Exchange Traded Fund (ETF).” Investopedia, Dotdash, 3 May 2021.

CFA Society Switzerland, et al. “HANDBOOK ON SUSTAINABLE INVESTMENTS Background Information and Practical Examples for Institutional Asset Owners.” CFA Institute, 2017.

Bell, Heather. “ETF Launches.” ETF.com, 18 May 2021.

“Leveraging the Potential of ESG ETFs for Sustainable Development.” UNCTAD, 2020.

Nickolas, Steven. “SPY: SPDR S&P 500 Trust ETF.” Investopedia, Dotdash, 23 Dec. 2020.

“Fund ESG Transparency: Quarterly Report 2021.” MSCI, 16 Feb. 2021.