VettaFi Voices On: The Case for the "E" in ESG ETFs This Earth Day

With Earth Day arriving this week, the VettaFi Voices had ESG investing on their minds — particularly, the “E.” After a difficult 2022 for ESG ETFs and strategies, where should interested investors even start? More importantly, should they even bother — or are ESG ETFs a fad whose time in the spotlight is already up?

Dave Nadig, financial futurist: A few initial thoughts: First, I think separating out the “E” from “ESG” can make a lot of sense. While we lump them all together, it’s largely because they all represent less-tangible parts of corporate risk. But fundamentally, there’s no a particular reason why, for example, measurements of how well a company manages its regulatory risk (namely, a governance issue) should be considered in the same sentence with how a company manages its emissions or water usage.

Lara Crigger, editor-in-chief: Absolutely agree with what you’re saying — though, to play devil’s advocate, ostensibly how a company manages its emissions and water usage is the same as how it manages regulatory risk. (Or, at least, it would be in a society where regulation was functioning properly as a check-and-balance, and institutions hadn’t been subject to systemic erosion and stress failure.)

That said, I’m not sure separating out or focusing on the “E” in “ESG” will even make that much impact. I’m all for free market solutions, but if you look at the big environmental wins over the past 50 years, from taking lead out of gasoline to discontinuing the use of chlorofluorocarbons, it’s all come from government-imposed regulation. Increasingly, I’m skeptical of the ability of the capital markets to move the needle on climate change at all, at least at the sort of scale we need on an existential level.

Todd Rosenbluth, director of ETF research: Happy Earth Day, everyone.

Crigger: I’m coming in hot. Like the surface of our planet in the next 10 to 20 years.

Rosenbluth: Yes, the public narrative on ESG has possibly shifted, with this getting mixed in with politics. But a couple weeks ago, we just had the most successful launch for an ETF ever from DWS, with the Xtrackers MSCI USA Climate Action Equity ETF (USCA) pulling in $2 billion. The money flowed out of another broad ESG ETF from DWS — USSG — but this proves Dave’s point: Breaking the “E” out from the broader “ESG” acronym is important to many investors.

Crigger: They basically just shifted money from one fund to another, though. In my opinion, that’s not evidence of an organic upswell of investor interest in “E”-focused ESG strategies so much as it is evidence that a single large institution wanted refinements on an ETF that had essentially been custom-built for them.

I know I sound like a Negative Nelly, and I actually think that some thematic or narrowly focused clean energy/energy transition ETFs — ETFs focusing on, say, certain segments of renewable power, smart grid and smart infrastructure, miners of critical metals, and so on — have truly promising investment cases for our future economic realities. So let me be clear that my skepticism is directed toward specifically broad-based strategies that rank companies according to some opaque ratings scheme, in the hopes of allocating capital to companies doing the ‘E’ aspect of ESG right. I think the transparency of that approach is questionable, its impact difficult to quantify, and investors would be correct to be skeptical.

Roxanna Islam, associate director of research: I do agree with Dave’s first statement on separating out the “E.” Good analysts typically have always included social and governance issues in their analysis, but environmental analysis is something that I think is relatively new and was not considered as much in the past. There’s some obvious sectors and industries which have historically had more controversy with environmental factors — like transportation, energy, and commodities mining.

For example, I think the railroad Norfolk Southern (NSC) illustrated some of the biggest ESG issues in recent history, due to several high-profile derailments causing environmental damage. Derailments are actually nothing new in the railroad industry. But with social media and more attention being paid to ESG, it’s becoming more of a visible issue. Since its big February 3 derailment, Norfolk Southern’s stock is down now almost 17%! And now the company has to deal with lawsuits in addition to the ~$6.5 million it pledged to the community. So, these issues aren’t cheap.

But the “E,” “S,” and “G” are also all very related. I think the hardest part for some companies is to balance ESG with their relationship with analysts and shareholders. Companies are pressured to cut costs, increase profits, and try to raise their stock prices. But that’s difficult if the areas where they’re cutting costs are in labor, safety, and other ESG silos. Overall, though, there seems to be a bigger push to be transparent; most companies have their sustainability report front and center on their investor relations websites. Even crypto companies have been actively addressing ESG issues over the past couple of years.
I think it’s also hard for investors, because ESG is both qualitative and quantitative. There’s not really a set standard for ESG analysis. I read a recent study about how ESG ratings are highly uncorrelated, as compared to bond ratings, so it’s difficult to address this on your own as an investor, without relying on an ETF.

Crigger: Exactly. The efficacy of ESG ratings is just not where it needs to be in order to be useful as a benchmark for investment strategies, in my opinion. There’s too much variance and not enough transparency. I mean, let’s not overlook that “ESG” as a category includes everything from solar power ETFs to biblically focused ETFs like CATH and BIBL.

Though I’m not opposed to ESG ratings or analysis becoming table stakes for active managers, who might incorporate them in their process as a first principle or as a selection screen, I just don’t think ESG analysis on its own is enough of a raison d’être to justify an ETF. Rather than invest in companies that may have gotten a certain grade for reasons I’m not really clear on, I’d rather just invest in companies whose profit model is directly tied to making the earth more habitable.

For me, I think some of the most promising “E” ESG ETFs would be ones focused on improving and upgrading infrastructure — water, smart grids, smart buildings, and so on — and the ones focused on miners providing the materials needed for to fuel a clean energy transition. Sprott just launched a nickel miners ETF, for example. That product, NIKL, is endlessly fascinating to me, as nickel is one of those materials you just don’t think of as a “clean energy” metal, but you basically can’t build an electric vehicle without it.

Nadig: If you do want to consider investing in a targeted clean energy fund, essentially looking to profit from an increased allocation of capital towards solutions, then the big leaders in the clean energy side are a mix of big names (the iShares Global Clean Energy ETF (ICLN), the First Trust NASDAQ Clean Edge Green Energy Index Fund (QCLN), the JPMorgan Climate Change Solutions ETF (TEMP)) and smaller funds with more targeting, like, say, the Invesco Solar ETF (TAN).

Rosenbluth: TAN was recently the top-performing ETF over five years, based on VettaFi data, proving that helping the planet can actually help your portfolio. I also think the ALPS Clean Energy ETF (ACES) is an interesting one, as roughly a quarter of assets are in electric vehicles and a quarter in solar, with the remainder split between wind, bioenergy, and hydro.

Nadig: One interesting fund I’d point to from a smaller firm is the Engine No 1 Transform Climate ETF (NETZ). NETZ isn’t necessarily buying just companies building windmills and such. They’re investing in the companies that stand to do the most by de-carbonizing and the ones who are actively doing so. So big holdings end up being things like Union Pacific (UNP) and Waste Management (WM) — not what most folks think of. But there’s a genuine throughline on why that approach makes sense.

Rosenbluth: Dave, I see your NETZ example and offer the KraneShares Global Carbon Transformation ETF (KGHG), which focuses on companies in high-emissions industries on the cusp, per active management, of transitioning from fossil fuels to renewable technology. So it owns BP (BP), Baker Hughes (BKR), and Schlumberger (SLB), which is certainly a different approach than TAN or ACES. Not only are ESG ETFs not all alike, but neither are all “E”-focused ETFs.

To the question of whether environmentally focused ETFs can be a huge success, I answer yes, as long as people appreciate that many of these are more narrowly focused and closer to the thematic ETFs we discussed last week that focus on robotics. (See: “VettaFi Voices On: AI, Robotics, and Opportunity.”) These funds can complement a broader portfolio that has the a non-environmentally based core like the S&P 500.

The broader market ESG ETFs — like the Xtrackers MSCI USA ESG Leaders Equity ETF (USSG) or even larger ones like the iShares ESG Aware MSCI USA ETF (ESGU) — are intended to be a replacement for the S&P 500 and have sector balance. So you will end up with a portfolio of companies that are not necessarily environmentally friendly but because they are the best of the bunch within the energy sector.

Islam: Wherever there’s an area with issues, that also means there’s room for improvement, which could equal growth. Kind of like what Dave mentioned with NETZ, which invests in companies that are actively investing in net zero. So you can look at ESG investing by negative screening for exclusions, but you can also look at it by positive screening for companies that contribute to the environment. Besides clean energy, there are also other environmental factors that are important, like the availability of natural resources, water, and agriculture. So an ETF like the Invesco Water Resources (PHO) would also fit into an ESG theme.

Rosenbluth: I think PHO, which I think accidentally has a cool ticker, was the first thematic ETF. It launched in 2005 before the terms “ESG” and “thematic ETFs” were considered mainstream.

Islam: I actually didn’t know that. That’s a fun fact for parties (maybe just ETF parties). I’ll remember to use it next year at Exchange.

Rosenbluth: Nice plug for Exchange, where I hope we again try to help the environment through charitable efforts. While Earth Day is this weekend, we need to help Earth daily.

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