ETFs

ETF Strategy Ideas Report: How do ETFs incorporate ESG factors?

July 15, 2021 - 5 minutes

There is a myriad of ETF options for investors. In the interest of demystifying a more complex area of focus – Environmental, Social and Governance ETFs – our most recent ETF Strategy Ideas Report takes a closer look at ESG ETFs. We explore what ESG ETFs are, the benefits of investing in them, and how they incorporate ESG factors.

Below is an excerpt from the report outlining the most common criteria used by ETFs to be considered more ESG-friendly.

Exclusionary screening

Also referred to as negative screening, exclusionary screening revolves around a set of criteria to remove companies with unfavourable ESG characteristics from a broader benchmark.

Severe controversy screens: The overwhelming majority of ESG ETFs have some form of screen to exclude companies involved in controversies deemed to be very severe, posing significant risks and negative impact for stakeholders. Severe controversies can result from the company's business practices or failed internal controls. For example, companies with a practice of using child labour, involved with bribery or fraud charges, or having caused significant environmental damage may be excluded based on severe controversies.
Business involvement screens: These screens seek to exclude companies that derive a significant portion of their revenues from several so-called sin industries, or companies that are not in compliance with certain religious or moral principles. Common industries that are filtered out from ESG ETFs include tobacco, weapons, alcohol, gambling, adult entertainment, nuclear power, fossil fuels, etc. Although straightforward to implement and justify the motivation behind these screens, the tradeoff is that many industry exclusionary screens create greater benchmark tracking errors.
Carbon intensity: ESG ETFs may use emissions data provided by company reports or third-party providers to exclude companies that are the most carbon intensive in their comparable groups. These ETFs may also use a multifactor approach so that carbon intensity is one of the factors, among other factors such as valuation and growth potential, in its security selection. The result is ideally a "cleaner" portfolio with a lower tracking error.

Inclusionary screening

Inclusionary screening, also known as positive screening, seeks to only include companies with favourable ESG characteristics.

ESG leaders: Several ESG data providers assign an overall ESG rating or score to each company, using a numeric or letter scale similar to bond ratings. The ratings are generally based on relative ESG performance compared to industry peers and take into consideration different ESG issues that may create risks or opportunities in each sector. The goal is to identify and overweight companies that are ESG leaders in their respective industries, and underweight or outright exclude companies that are ESG laggards compared to their peers. This method typically does not have a sector bias and seeks to minimize tracking error to a broader benchmark, while systematically overweighting companies with high ESG rankings and underweighting companies with poor ESG performance. One caveat of this approach is that, depending on the ESG rating agency, the score assigned to each company may be materially different. Investors and organizations around the globe have sought for greater standardization and more transparency when it comes to ESG scoring practices, but at this stage there are no internationally (or even nationally, for the most part) recognized regulatory bodies overseeing this endeavour.
Gender diversity: Certain ETFs may employ a gender diversity screen which only includes companies that have adequate female representation on the board or at the senior management level.

Thematic investing

Thematic investing in companies and sub-industries benefit from trends in sustainable investing. Thematic investing tends to place greater emphasis on the environment. Some examples of thematic ETFs include funds focused on renewable energy companies. Additionally, funds that emphasize the social factor (i.e. gender diversity funds), may also be viewed as thematic investing. Certain funds may also invest in multiple themes as deemed appropriate by the portfolio manager.

Impact investing

The rationale behind implementing these criteria is to include companies that are addressing sustainable development issues, often defined by the blueprint established by the United Nations' 17 goals. These goals range from basic needs such as eradicating poverty and providing access to clean water, social goals such as promoting equality and quality education, to environmental goals such as increasing energy efficiency and managing natural resource usage. The antecedent of impact investing is that an organization's impact on ESG issues is measurable, which can be challenging for certain issues. For MSCI, impact investing is measured by share of revenues derived from business lines which address sustainable development goals or by capital investment made in alignment with those goals. In our view, impact investing straddles between philanthropy and capitalism, as its objective is to maximize the ESG impact of one's investment while also generating a return on capital.

ESG integration

This approach generally refers to the integration of ESG data in the investment decision-making process, often from the perspective of active managers. ESG integration can be highly discretionary in nature and may take on the form of using ESG information as a factor either from a quantitative perspective or as part of a qualitative competitive analysis approach. ESG integration may also involve engaging in dialogue with portfolio companies about the sustainability of their practices, with the goal of improving their ESG performance.

Subscribing clients can access the full report by logging into our research portal

Andres Rincon
Director and Head of ETF Sales & Strategy, TD Securities

Biography

Andres Rincon heads ETF sales and strategy at TD Securities. His ETF team advises both institutional and wealth investors on the ETF landscape and strategies, publishes a broad array of ETF publications, and works with TD's ETF market making team in facilitating ETF orders. Andres joined TD Securities in 2008, first managing credit risk for the dealer, and later as a member of the Equity Derivatives division. He later took on the task of expanding TD Securities' ETF sales and strategy platform. He is also a Chartered Market Technician (CMT).