ETF Trends
ETF Trends

Note: This article is courtesy of Iris.xyz

By Marie Dzanis

Until now, much of the growth in environmental, social and governance (ESG) investing has been concentrated among large institutional investors. But the number of financial advisors considering ESG investment products is starting to grow – whether because of idealistic convictions, updated investment guidelines or risk-reduction objectives. The merits of ESG investing have been trumpeted for years. So why have asset flows to date lagged across retail and advisor channels? We believe that a disjointed array of investment approaches and weak risk-adjusted performance versus non-ESG alternatives has inhibited uptake. However, we also believe that the mainstream investor marketplace is eager for ESG products that combine an integrated approach to ESG best practices with enhanced risk-adjusted returns.

TO DATE, DISPARATE APPROACHES, LIMITED APPLICATION

Seven distinct approaches to ESG investing have emerged over time (see Exhibit 1). These approaches did not evolve in linear sequence but, rather, sprang from a mix of top-down

(e.g., boards of directors embracing ESG principles) and bottom-up drivers (e.g., investors demanding ESG accountability from public corporations). Implementation varies from approach to approach, but the resulting approaches typically feature poor diversification and skewed returns that have been difficult to use in standard asset allocation models.

For example:

  • A negative exclusion approach may remove certain industries/sectors from investment consideration but cause increased tracking error versus market weighted benchmarks.
  • A sustainability-themed investment may concentrate risk in certain sectors.
  • Impact-type investors argue that the most effective way to get companies to address social or environmental problems is to become an “activist” shareholder. Progress is achieved by engaging with management to set goals and regularly disclose progress.

Whatever the approach, if an ESG product is not properly diversified, its application typically is limited.

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SPOTTING AN OPPORTUNITY

Large institutional investors dominated the early stages of ESG investing because they possessed the requisite expertise and governance protections of well-resourced investment committees. Typically, they invest through separately managed accounts (SMAs) or overlays exhibiting limited asset diversification. Such account structures are not workable, by contrast, for retail and advisor channels, or for institutions that lack committees of investment experts, due to asset diversification requirements and account size thresholds. Herein lies the market opportunity to create a scalable, performance-driven ESG investment vehicle.

To facilitate product development applications, index providers have started to rely on key performance indicators (KPIs) reported by public companies in their regulatory filings. KPIs are quantitative and qualitative metrics that demonstrate how effectively a company is achieving its business objectives, which often include environmental, social or governance considerations.

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