The Rise of ESG: A Look into the Future of Sustainable Investing

25 Apr 2023
By Danish Lim, Investment Analyst, Phillip Nova

ESG on the rise

In recent times, interest in ESG related issues has been on the rise, even becoming embroiled in political debates in Washington- with President Joe Biden recently veto-ing a Republican proposal to bar 401(k) plans and other workplace retirement plans from offering ESG funds. Naysayers and sceptics have blasted ESG funds as just a form of “woke” investing.

MorningStar reported that 2022 ESG net annual inflow of $3.1B was well below the average $47B over the past 3 years. I think that mainly the negative broader market environment drove this, with a majority of sectors underperforming in 2022. At the same time, ESG ETFs were typically underweight Energy, which was the top performer in 2022.

Source: Bloomberg Price Return 12/31/21 – 12/31/22

 

Looking into the data, the S&P 500 ESG Index has actually outperformed the broader S&P 500 index over the past 10 years. It is also up by 8.89% YTD, slightly better than the S&P 500 at 8.20%. I would attribute this outperformance to a majority of ETFs being overweight ESG friendly sectors such as Tech, which has outperformed so far in 2023.

 

Source: Bloomberg 2023

 

What factors investors should take note of?

When looking for an ESG ETF, investors should take a deeper look at the funds’ holdings and make sure that it aligns with their value. For example, if you are against gun violence, you should look for ETFs that exclude companies with exposure to the weapons industry. Similarly, a high sector exposure to Energy may not be ideal. In this scenario, there have been instances where funds holding Energy stocks still rank quite highly in terms of ESG ratings. Thus, due diligence is recommended when it comes to looking at the fund’s underlying holdings.

ESG ratings scored by independent organizations such as MSCI, S&P Global, and MorningStar should also be taken into account. According to Morningstar, Apple has a “low” ESG risk rating of 16.91, while Tyson Foods has a “high” ESG risk rating of 36.53.

Investors should also look at the fund’s Expense Ratio, which is a crucial aspect of ETF investing as higher expenses can eat into profits. It is also important to note that ESG funds can be divided into passively or actively managed funds, with active funds typically having higher Expense Ratios.

Risks for investors when investing in ESG ETFs

Narrow your investment opportunities

Investors run the risk of sacrificing returns by leaving profitable investments on the table. For example, an ESG investor likely would have suffered losses in 2022 by missing out on Energy stocks. Exxon grew by roughly 80% in 2022.

Risk of becoming under-diversified & Greenwashing

The pool of ESG-compliant companies is typically smaller than the pool of available publicly traded companies. Companies may also make false and misleading claims about their ESG practices to entice would-be ESG investors and make a profit.

However, I am of the opinion that pros of ESG investing outweigh the risks.

 

Benefits for investors when investing in ESG ETFs

Lower downside risk

Companies with proactive ESG policies should see fewer business disruptions and produce more stable profits over the long-run. ESG issues may generate negative publicity and threaten corporate profitability. E.g. Volkswagen’s emissions scandal in September 2015, or “Dieselgate”, contributed to a -36% slump for the month of September.

Align your investments with personal values

Reward ethical companies and encourage other corporations to uphold similar values. Achieve twin goal of generating profit while aligning your investments with personal values.

Expert watchlists & why these are worth investing in:

  1. Vanguard ESG US Stock ETF (ESGV), Expense ratio 0.09%

This ETF tracks the performance of the FTSE US All Cap Choice Index. It has a well-diversified pool of stocks, 70% of which are large caps. The fund is based on exclusionary principles- excluding companies with exposure to industries like weapons, tobacco, gambling, and adult entertainment. ESGV’s exposure to the energy sector is nearly 0%, but has around 32% exposure to Tech, 16% to Consumer Discretionary, and 15% to Healthcare.

2. VanEck Green Bond ETF (GRNB), Expense ratio 0.20%

The fund seeks to replicate the performance of the S&P Green Bond US Dollar Select Index. Its holdings are mainly comprised of “green bonds” that were issued by governments or corporations to fund environmentally friendly projects. The fund has a MorningStar 4-star rating. It also has a 12-month yield of 2.71%. GRNB is most heavily weighted towards the Financials (38.3%) and Utilities (20.3%) sectors.

3. iShares Global Clean Energy ETF (ICLN), Expense ratio 0.40%

The fund aims to track the investment results of the S&P Global Clean Energy Index. It provides exposure to companies that focus on producing clean energy from solar, wind, and other renewable energy sources. Some of its largest holdings include renewable energy stocks such as First Solar, Vestas Wind Systems, and Enphase Energy.

Future Outlook for ESG:

In the long-run, as the world becomes more aware of ESG-related issues, ESG considerations could start to play a greater role in people’s investment decisions and consumer preferences. In my opinion, ESG analysis can serve as a complement to traditional financial analysis by helping investors evaluate non-financial risks that typically goes unnoticed.

Increased availability of standardized ESG data and improved reporting standards can help investors and managers make better investment decisions. In December 2022, the EU adopted the Corporate Sustainability Reporting Directive (CSRD), which expanded the number of companies that are required to report sustainability information, from around 12,000 to 50,000. Therefore, over time, we could start to see ESG information being further integrated into fundamental analysis.

Do you have questions for Danish or you want to deep dive into how to build your personalised portfolio?

Hear from the experts: Danish Lim, Investment Analyst from Phillip Nova and Alvin Chow, CEO of Dr. Wealth.

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An Exchange Traded Fund (ETF) is a marketable security that is formed to track nearly anything, ranging from a specific index, sector, commodity, or increasingly, theme. They are most commonly used to track a basket of stocks, and can typically be accessed through the same channels as regular stocks. ETFs are typically separated into passively-managed ETFs that simply mirror the security they are tracking (e.g. the STI), and actively managed ones that attempt to deliver higher returns or specific investment objectives, often with a pre-specified theme in mind (e.g. ARK Invest’s Innovation ETF).

Why should I trade in ETF CFDs?

  • ETFs have been growing in popularity over the years. 2020 was the best year for ETFs yet, with global equity ETFs seeing more than $1T in inflows within a 12-month period. Using CFDs to gain exposure to ETFs allows for greater capital efficiency because only a portion of the contract value is required as margin to establish a position.
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  • An investor wanting exposure to the post-pandemic economic recovery could open a position in the well-known SPDR S&P 500 ETF (SPY), which tracks the performance of the S&P 500. Another investor that may be convinced of the future importance of Environmental, Social and Governance concerns (ESG) may find the increasing selection of ESG-themed ETFs that track a basket of high ESG-rating companies to be a good investment, rather than cherry-picking individual equities by hand. ETF CFDs can act as a powerful tool for traders can profit from both directions of the market by taking on long or short positions.

A look at two ETF CFDs we offer:

1) Has the ARKK been sunk?

ARK Innovation ETF (ARKK) ARKK is an actively managed ETF by ARK Invest that invests in a range of companies based on their innovative and industry-disrupting potential. ARKK’s largest holdings are in companies such as Tesla, Square, and Zoom. ARKK is down around -33% from peaking on 12th Feb and is currently in the red for the year to date as the market experiences a risk-off outflow of funds. Superstar fund manager Cathie Wood has however been consistently doubling down on her bets, buying even more shares in growth stocks that are going through their own tumultuous periods such as DraftKings, Peloton, Teladoc, and Tesla. In her view, ARKK is playing the long game, and remains steadfastly convinced in the long-term prospects of these growth stocks beyond this current bout of volatility. Similarly on outflows, investors are still betting big on ARKK as ARK Invest has only lost about $1.2B in assets this year across all its six funds, compared to seeing an inflow of $15.1B during the same period. Recently, investors have been nervously eyeing ARKK’s basket of tech stocks as their future earnings potential remain vulnerable to erosion through high inflation – the dominant concern of the market in recent weeks. As commodities – the major contributor to the recent heightened inflation fears – drops sharply from record highs, are investor concerns over hyperinflation overblown?

2) Searching for exposure to Asian equities?

iShares MSCI Asia ex Japan ETF (AAXJ) The AAXJ is currently trading -10.6% adrift of all-time highs seen in February, giving up gains in tandem with an Asia-wide equity sell-off at the time. Given that slightly over 40% of the ETF’s holdings are based in China, the ongoing tumult seen in Chinese equities currently have carried over nearly perfectly in the AAXJ, as Chinese investors take a breather after the stellar gains made over the past year. Looking ahead, Asia – and particularly China, is steaming ahead with its economic recovery. China is widely expected to be one of the best-performing major economies this year, providing a major boost to the outlook for corporate earnings. As the rest of Asia and the world gradually opens up their own economies, AAXJ is likely to again benefit from strong Asian outperformance amidst a strengthening trade outlook.

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