Can ETFs Persist in the ESG Space | ETF Trends

By Derek M Horstmeyer

Since 2018, 125 new ESG Equity ETFs have been created in the US. This explosion of new products has been met with 17 Billion dollars in inflows into these ESG ETFs by investors – far, far more than any other asset class on a percentage basis.

This sounds all well and good for ESG ETFs, but when one takes a look under the hood, there appear to be a few cracks in the system – even with these massive inflows, we are not seeing reductions in expense ratios or spreads that one would expect. This leaves one asking, can ESG ETFs continue to persist, or are investors better off holding other ESG products if they desire this exposure in their portfolio?

ETFs differ from mutual funds in that they trade actively throughout the day, and therefore there is a difference between the price that an investor can buy at and what they can sell at (referred to as the bid-ask spread). The lower the daily volume of ETF trading, the higher the bid-ask spread. This bid-ask spread is a hidden cost for investors when dealing with ETFs (not present for mutual fund buyers) and truly should be considered with the expense ratio when calculating the total transaction costs in ETF investing.

Now, if an ETF provider can encourage investors to actively buy and sell their product, then the bid-ask spread will remain low, and the ETF will have a good chance of surviving. The fundamental flaw with ESG ETFs is that because ESG investors tend to be buy-and-hold investors, this may be difficult to do without actively encouraging non-ESG investors to come and trade your product. Mutual funds in the ESG space, on the other hand, don’t face this issue of having to attract active traders since they only trade once a day at days-end, and have no bid-ask spread.

In conjunction with Oriela Poga and Sufia Abdul Rauf, we start by analyzing the full universe of equity ETFs issued in the US in the last five years and then separate all ETFs by their stated equity concentration. In particular, we isolate all ETFs that have a sustainability focus (clean energy, other environmental factors, etc.), impact focus, or ESG designation in US equity markets (yielding 125 ‘ESG’ ETFs). Next, for each of these ‘ESG’ designated ETFs, we match them to a non-actively managed ETF based on their closest benchmark, to have a comparable ‘plain vanilla‘ ETF to compare them to.

The first salient feature is that on a match-pairs basis, the group of ESG ETFs have seen far greater inflows than their counterparts. In 2018, ESG ETFs saw inflows of 83% of starting AUM, while their matched pairs saw inflows of 23%, leading to a difference of 60%. These excessive inflows continued in 2019 and 2020 as well for ESG ETFs.

And more importantly, despite these inflows, the average ESG ETF has not seen their expense ratio or bid-ask spread drop over this time. On a matched-pairs adjusted basis, the average ESG ETF has seen their expense ratios go from 0.08% higher in 2018 to 0.10% higher in 2020. In 2018, the average ESG equity ETF had an expense ratio of 0.29%, while their matched pair had an expense ratio of 0.21%, a difference of 0.08%. In 2020, the average ESG equity ETF had an expense ratio of 0.28%, while their matched pair had an expense ratio of 0.18%, a difference of 0.10%.

And over this period, the average ESG ETF has seen their bid-ask spread actually increase on an adjusted basis as well. In 2018, the average ESG equity ETF had a bid-ask spread of 0.21% while their matched pair had a bid-ask spread of 0.10%, a difference of 0.11%. In 2020, the average ESG equity ETF had a bid-ask spread of 0.20% while their matched pair had an expense ratio of 0.08%, a difference of 0.12%.

This means that the transaction costs to dealing with ESG ETFs have actually gotten worse despite a considerable amount of money flowing into these new products – just the opposite result one would expect.

For instance, the best ESG ETF out there in terms of lowest bid-ask spreads is currently SUSL (iShares ESG MSCI USA Leaders). This ETF has a bid-ask spread of 0.05% and an expense ratio of 0.10% – which means all told the costs to an investor in a round-about trade is .15% of the amount invested.

This ETF focuses on many large-cap companies here in the US, and because of this, a comparable match-pair would be the iShares Core S&P 500 ETF (IVV), which comes in with a bid-ask spread of .01% and an expense ratio of .05%. This means that altogether the costs to investors in a round-about trade is 0.06% of the amount invested—half the total expenses as the ESG ETF.

All told this doesn’t spell the best of news for the long term survival of ESG ETFs. And, perhaps a few of the cracks are beginning to show. Since 2018, we have witnessed a 6.8% closure rate of ESG, while ESG mutual funds have had a 4% closure rate over the same period. If ESG ETFs are going to continue to survive, fund providers are going to have to think of a way to encourage trading and reduce spreads. An easier thing said than done.