By ESG Analyst Matthew Redmond
ESG ETFs are an excellent way for individuals concerned about their investments’ impact and want their values to be reflected in their financial decisions. ESG ETFs can provide the same benefits as other ETFs, such as diversification, low cost and ease of trading while aligning with investors’ values by focusing on companies that meet specific ethical guidelines.
What are ESG ETFs?
ETFs, or Exchange Traded Funds, are a type of investment that “pools” a basket of securities such as stocks, commodities or bonds and allows investors to gain exposure to an array of assets. These have many benefits, such as often having lower volatility and higher diversification, as they are an average of all their underlying assets. They also are easier to invest in than creating a similar type of asset pool on one’s own and have much lower costs than similar investments like mutual funds. Many ETFs track specific sectors such as energy, technology, consumer staples or healthcare.
ESG ETFs are a type of ETF that focuses on companies with specific ESG goals so that investors can make more socially conscious investments. Different ESG ETFs seek to create investment solutions with ESG goals in various ways. Some seek to screen and exclude certain companies that receive revenue from non-ESG sources, such as firearms, tobacco, or fossil fuels. Others focus on specific ESG issues such as water and air, alternative energy, food, and agriculture. Some don’t focus on particular sectors but pool different companies across industries with strong ESG commitments. All these types of ESG ETFs have the potential to make real impacts in ESG and to help investors invest responsibly.
The benefits of ESG ETFs
The ethical benefits of ESGs go beyond simply satisfying the conscience of their investors. They also can create real change in how different companies and industries behave. The main goal of publicly traded companies is to maximize shareholder returns, that is, the benefits shareholders receive by investing in the company. When investors pull away from a company by selling shares or choosing not to buy them, it creates negative pressure on the stock’s price, leading to a decline in the company’s value. This price decline, in turn, reduces the returns for remaining shareholders in the company, which pushes the company to change its behaviour and entice more investment into the company. Therefore, ESG ETFs can pull away capital from problematic companies and push them to change their behaviour for their stock to recover, as well as further reward companies with ESG goals.
ESG ETFs can also make it more difficult for companies with unsatisfactory ESG results to raise capital for projects and make it easier for companies with good ESG results. If investors refrain from investing in companies with poor ESG results, these companies will likely face greater difficulty raising capital. This difficulty in securing funds through debt or equity may limit their ability to continue or expand their operations.
Financial benefits of ESG ETFs
Some investors may be concerned with the performance of ESG ETFs compared to non-ESG ETFs or other similar investments, as they want to maintain their returns but also integrate personal values in their investments. Luckily, as further detailed below, there is plenty of evidence to suggest that ESG ETFs can perform similarly to or even outperform their non-ESG counterparts.
Companies with ESG goals have many strong fundamentals that companies with non-ESG goals may lack. Governments may be more inclined to award access, licenses and approvals to trusted corporate actors, such as companies with strong ESG goals. Companies with ESG goals may have lower input costs, which can significantly increase profitability. In the example of 3M, the company has saved over USD 2.2 billion by preventing pollution up front by reformulating products, improving manufacturing processes, redesigning equipment and recycling and reusing waste from production. Such companies may also have consumers who are more loyal to them and willing to pay premiums because they value the company’s commitments to ESG goals.
Many studies have shown that these theories play out in real life. For example, an aggregation in the Journal of Sustainable Finance & Investment reviewed over 2,000 studies measuring the financial performance of ESG initiatives. It found that 63% reported positive returns on equity from strong ESG propositions, while only 8% reported negative returns.
Specifically for ESG ETFs, a study conducted in the International Review of Financial Analysis found that ESG ETFs do not necessarily underperform their non-ESG counterparts and, in some cases, outperform them. In the latter half of the study period, 2010-2020, the ESG stocks significantly outperformed.
Concerns with ESG ETFs
One concern with ESG ETFs is the risk of greenwashing, which describes an organization making false or misleading claims about its environmental impact. Some worry that companies in ESG ETFs are not adhering to the claims they make about their environmental, social and governance goals. However, research suggests that greenwashing is relatively minimal in ESG ETFs as this would likely lead to swift scrutiny by investors, the media and regulatory agencies.
A more pressing concern in ESG ETFs is their lack of comparability. The massive proliferation of ESG ETFs in recent years has made it nearly impossible for investors to distinguish between them. Investors will have difficulty differentiating between these ETFs regarding the area of ESG focus and their performance record. Ryan Clements of the University of Calgary notes, “Popular ETF information aggregator sites do little to ease this comparative burden since they add diverse ESG sub-rating categories, some of which are also behind paywalls” (Clements 2020). These sites list over 1000 ETFs meeting some ESG criteria. These factors will make it a challenge for individual investors to decide on their own which ESF ETFs to invest in.
However, many financial institutions now recognize these challenges and offer dedicated advisory services to guide investors in selecting ESG ETFs that align with their values and investment objectives, making the process more manageable.
Conclusion
Despite drawbacks, EGS ETFs still provide a unique opportunity for investors to create diverse, low-cost investments with competitive returns while contributing to meaningful change. By allocating capital toward companies that prioritize ethical practices, these ETFs encourage businesses to adopt sustainable and responsible strategies. Given their potential for ethical impact and solid financial returns, investors prioritizing ESG goals should strongly consider incorporating ESG ETFs into their portfolios.
References
- Clements, Ryan. (2022). Why comparability is greater problem than greenwashing in esg etfs. William and Mary Business Law Review, 13(2),441-486.
- Dumitrescu, A., Järvinen, J., & Zakriya, M. (2023). Hidden Gem or Fool’s Gold: Can passive ESG ETFs outperform the benchmarks? International Review of Financial Analysis, 86, 102540. doi:10.1016/j.irfa.2023.102540
- Environmental, social, and governance (Esg) etfs. (n.d.). Schwab Brokerage. https://www.schwab.com/etfs/types/socially-responsible-etfs
- Esg investing & funds. (n.d.). BlackRock. Retrieved 13 November 2024, from https://www.blackrock.com/us/financial-professionals/investments/products/sustainable
- Ferri, R. A. (2009). The etf book: All you need to know about exchange-traded funds. John Wiley & Sons.
- Friede, G., Busch, T., & Bassen, A. (2015). ESG and financial performance: aggregated evidence from more than 2000 empirical studies. Journal of Sustainable Finance & Investment, 5(4), 210–233. https://doi.org/10.1080/20430795.2015.1118917
- Henisz, W., Koller, T., & Nuttall, R. (2019, November). Five ways that ESG creates value. McKinsey & Company. https://www.mckinsey.com/~/media/McKinsey/Business%20Functions/Strategy%20and%20Corporate%20Finance/Our%20Insights/Five%20ways%20that%20ESG%20creates%20value/Five-ways-that-ESG-creates-value.ashx
- Petrova, E. (2016). A brief overview of the types of etfs (SSRN Scholarly Paper No. 2728144). https://doi.org/10.2139/ssrn.2728144