Risks and Traps with (ESG) ETFs

Hi everyone,

I came across a study about the great asset growth of ESG ETFs which implies at first glance that sustainable strategies are gaining traction, but here is quick summary about I want to say on (ESG) ETFs in general:

• The ETF industry has enjoyed another great year of growth in 2019 with an increase in assets of roughly 10% to 4 trillion USD. It is unsure whether the asset growth of ESG ETFs is due because these products are ESG or ETFs.
• Many funds are rebranding their OM to incorporate ESG because of market interest. It is not obvious whether an ETF complies with a set of ESG standards (compliance view), whether it drives on quantitative sustainable factors (performance view) or whether it just uses ESG terminology as a marketing tool.
• Some ESG ETFs can have negative or positive screening based on ethical values, environmentally/socially friendly attributes or value-driving factors based on sustainable considerations. There is a wide differentiation amongst them and it is not obvious in their name.
• There are many ESG rating firms out-there with different opinions. The average correlation between the ratings of a company is 60%, with the difference depending on the measurements and their aggregation. Sorting out one ESG value driver is difficult.
• Some ETFs restrict their entire investment universe on one sole metric, usually C02. I don't think shifting an entire strategic asset allocation on one sole carbon metric is an adequate use of current resources.
• Most of the companies reporting on sustainability are European-Large Caps. If you invest in an ESG ETF beware that you would probably get a geographical and size bias.
• ESG ETFs are ETFs before being ESG, whether they comply with a set of ratings or drive on sustainable factors, they are first and foremost passive solutions (active ETFs aside). It would be unwise to expect any form of responsibility-taking from the managers on their shares and expect them to push for corporate activism in sustainable shareholders resolutions.
• An ETF pricing mechanism works through a third-party market maker (Authorised Participant, or AP) that constantly rebalances the portfolio so that ETF's price remains close to its net asset value (NAV). It depends hence on the liquidity of the underlying portfolio. Many of ESG ETFs navigate in shallow universes because of the sustainable filtering. They are thus more constrained. Shall volatility spikes, trading halts occur, the AP would not be able to trade anymore and the price of the ETF would plunge. There is a liquidity risk to take into account.
• A passive ETF is a rule-based investing strategy that aims to water down all idiosyncratic risks in a portfolio and taking all the market or given sector risk. I think that is no longer a diversifying nor a defensive strategy.
• ETFs have enjoyed great growth for the last 10 years since the GFC. I think they have extensively enjoyed monetary support that has helped their pricing efficiency mechanism and boost their performance. I don't think they could keep the performance argument shall this support end.

Happy to hear your thoughts.

Best,

Nicola