The growing popularity of using ETFs in deploying ESG-based investment strategies among institutional investors is more than just a coincidence of timing and has implications for the retail investment space.

A survey from Invesco in August showed that more than half of all institutional investors (55%) believe that the majority of their ESG investments would be held within ETFs within the next five years while just under half (45%) said they would be increasing their ETFs ESG holdings in the next two years. Only 5% said they would be decreasing.

While there was not an “inevitability” about institutions using ETFs for ESG investment purposes, Chris Mellor, head of EMEA equity and commodity ETF product management at Invesco, said it certainly was the case that as ESG becomes more mainstream, the number of ETFs that cater for their needs has been expanding.

According to data from Morningstar, there have been 46 ESG ETF launches so far this year, as of 30 June, 11 more than the previous highest set in 2018.

“With a much wider range of options now offered in ESG ETFs it has become much easier for investors to use ETFs for ESG exposure,” Mellor continued.

“There is a clear benefit in using an index-based approach when applying exclusions and specific filtering requirements as the rules-based investing approach of an ETF means that investors know exactly what the fund will and will not invest in and therefore whether the strategy will meet their specific requirements.”

It is not a minor point that passive funds tend to be cheaper than active funds and therefore more attractive to institutions.

“Fees have been shown to be one of the most reliable predictors of future fund performance,” Kenneth Lamont, senior manager, research analyst, passive strategies, at Morningstar, suggested.

Moreover, in retail investment the average investor will also benefit from the “embedded” research resources put into an ESG index by the provider, Rumi Mahmood, head of ETF research at Nutmeg, said.

“While quality as well as quantity matters in any ESG dataset, the fact remains that index products use institutional quality tools to offer exceptional value for money for investors.”

ETF Insight: Are ETF and index providers taking ESG seriously?

On top of cost-efficiency, the transparency offered by ETFs means that investors can see exactly what is held in the fund by examining the make-up of the underlying index and this is also a factor when it comes to retail interest in ESG.

“From client consultations, we know that it is critical for ESG-attuned investors to have clarity over what they own, why and what difference it makes relative to a non-ESG solution,” Mahmood added.

Ben Seager-Scott, head of multi-asset funds at Tilney, agreed: “Perhaps the common theme (about ETFs and ESG) is about investor access and investors increasingly seeking more direct control over their investments.

“Part of that involves favouring index tracking, thereby eliminating the variability you get from just handing your money over to an active stock-picker to run.”

This is backed-up by the performance data, Mellor said. “Using Morningstar data, we found that on average active ESG funds underperformed ESG ETFs in the first quarter of the year and although they recovered somewhat in the second quarter, active underperformed passive in most regions in the first half.”

A wider question arises, however, when it comes to index composition and the ESG research work undertaken by the major index providers.

“An indexing approach is only as good as the quality of the input data,” Matt Brennan, head of passive portfolios at AJ Bell, highlighted. “When looking at some of the holdings that make it into the indices, it can sometimes be surprising as to what makes the cut.”

For example, Vanguard came under fire last year when the US giant was forced to remove as many as 29 stocks including gun manufacturer Sturm Ruger from the Vanguard ESG US Stock ETF and the Vanguard ESG International Stock ETF.

Why ESG should not be marketed as delivering outperformance

Meanwhile, Seager-Scott said ETFs tend to work well when employing a light-touch approach where companies that objectively score poorly in ESG factors are screened out.

“There remains a lot of discussion about what rules and measures are most appropriate for an ethical investor,” he continued. “ETFs are less able to look at the actual business models, they cannot really engage with management for positive change or use a more judgement-based approach.”

This is the idea that passive ESG funds suit investors looking to ensure their investments are “a bit less bad” rather than seeking to actively influence how a company behaves.

“Active is probably better if you want to do active good – and will likely have more divergence from broad asset class indices,” Seager-Scott added.

Lamont agreed that the rigid nature of passive investment might not lend itself to the world of ESG.

“For example, liquidity constraints mean that passive strategies have to steer clear of smaller, often more impactful companies,” he continued. “Those seeking the most ESG impact, might expect a level of engagement between fund management and portfolio company not possible in a passive wrapper.”

Is passive really aligned on ESG?

But whether ETF managers are quite the bystanders that might be supposed is questioned in some quarters. Mahmood pointed out that the ETF managers he speaks to are “highly engaged” when it comes to corporate governance and stewardship with an outlook every bit as long-term as with active managers.

Stewardship scores can vary greatly depending on the ETF issuer. A 2019 Share Action report rated Legal & General Investment Management (LGIM) an ‘A’ for its approach to stewardship “which demonstrates that passive investors can have a leading approach to responsible investment,” the report added.

“A fact often forgotten is many of the world’s largest ETF issuers have significant active management businesses allowing them to leverage significant governance resources in a cost-efficient manner.”