By Chris Mellor, Head of Equity and Commodity ETF Product Management, Invesco.
Chris Mellor, Head of Equity and Commodity ETF Product Management, Invesco.
Why is ESG on so many people’s minds today?
ESG is not a new concept, but it has certainly increased in popularity over recent years; this goes hand in hand with changes we are seeing in society.
In recent headlines, for example, we have seen the terrible fires in the Amazon region, and Greta Thunberg traveling around the world on a yacht to make a point about climate change. Concurrently, we are seeing the emergence of millennials as a social and economic force.
On top of these broad trends, from an investor perspective, there is growing evidence that environmental, social, and governance (ESG) factors must be taken into account.
Look, for example, at BP’s problems in the Gulf of Mexico, or Vale with the recent dam collapse in Brazil. Those events have had a significant impact on the performance of those stocks. So encouraging companies to deliver better practice and take a more focused view on avoiding those types of problems makes sense not just from a moral standpoint, but also from a financial standpoint.
Definitions of ESG are often confusing, new EU regulation is in the works but will it solve the problem?
Regulation is clearly on its way, the question is how much it will cover. In recent years a number of standards have been laid down by local regulators in different countries that are certainly valuable but the problem is that the rules vary slightly in each case.
The objective of developing some kind of framework for greater clarity and consistency makes a lot of sense, but the question is whether that can be achieved in a way that encompasses a diverse set of views and approaches; on top of that, the framework cannot be so restrictive that it potentially prevents investors delivering attractive risk-adjusted returns for their clients. Getting that balance right is always a challenge for regulators. Overall, though, greater clarity and simplicity for end investors in this area would be welcome.
How is your ETF constructed?
Invesco has a large active ESG proposition. From an ETF perspective, MSCI has produced a bespoke index for our fund, based on their standard universal methodology. It weights stocks based on their ESG score and their momentum-in-ESG score, overweighting the best-behaving stocks and underweighting the worst-behaving. In addition, we found that investors want the reassurance that there are certain areas they won’t be exposed to, so we put exclusions in place for tobacco, arms, or extreme polluters.
If a company breaches your ESG conditions, how does a passively managed fund handle the situation?
MSCI has strict criteria for stocks, and if there is a breach or observed behavior, it would generally result in a reduced weighting or, if it crosses our red lines, full removal from the index at the next re-balance.
In the event of a breach, is it better to divest from a stock or take an active ownership role and push for change?
Both approaches have their place. At Invesco, we have a strong internal ESG capability, consisting of a team dedicated to monitoring and being an actively involved owner of stocks, not just those in our actively managed portfolios, but also within our passive portfolios.
In the last year, for example, Invesco voted on 99.96% of all company votes in the companies we own on behalf of our investors. We certainly believe it is important to be actively engaged.
On divestment, specifically from an ETF perspective, if a company breaches a rule or drops below our standards, we follow the index rules, but the design of the index we follow tends to mean there are few full exclusions: in practice the weighting is likely to reduce substantially, which sends a clear message to company management. It’s about taking a pragmatic view.
There is also considerable evidence that selling stocks that receive an ESG downgrade makes sense from a finance perspective. According to research, stocks generally continue to underperform for at least 12 months after a downgrade. It’s similar to any negative shock or bad earnings numbers, these things continue to resonate for some time. Our process factors in this ‘negative momentum’.
Why are you launching ETFs in the ESG sector?
As with most new developments, those first on the innovation curve are ‘early adopters’ who have very particular and driven beliefs. But as we have moved further up the curve, we are seeing broader take-up and greater consensus on how we define ESG. This means that ETFs are able to offer a broader solution to this growing segment of the market.
This summer Invesco has done two things. Firstly, we’ve launched a range of ETFs that use the universal screening index approach, covering the US, European, and global markets. These are intended to give exposure similar to market-cap-weighted benchmark performance, but with built-in ESG and carbon exposure criteria.
Secondly, we launched an actively managed global ETF run by our quantitative strategy team. This has a global remit but is more concentrated, with a focus on 150 stocks. The ETF combines both ESG and factor investing criteria using these as potential long-term performance drivers from a fundamental perspective.
The first launch that uses universal screening aims to provide core beta exposure with ESG criteria. The second launch that is the actively managed ETF aims to deliver outperformance in an effective and ESG-compliant way.
What are the advantages of ETFs for ESG investing?
The obvious advantage is cost, which studies have shown can have a significant impact on long-term performance. Our new range has costs very close to those of our standard non-ESG market-cap-weighted ETFs, ranging from around 0.09% to 0.19%.
The other advantage is that ETFs allow investors to be very clear about what they own. They are extremely transparent about their methodology and their underlying holdings, which is not always the case with active managers.
What advice would you give to investors approaching ESG for the first time and considering ETFs?
As with any investment, they need to be clear about their objectives, for example, are they looking for lower volatility and drawdowns? But when adding to ESG they need to consider a range of other factors: what are their red lines, are there sectors they want to exclude entirely? These questions are highly individual.
Beyond that, they need to consider whether they want to actively promote certain areas – clean energy, for example. And beyond that, there is ultimately ‘impact’ investing, although that’s more the province of active management. As an industry, it’s our job to cover this entire spectrum and give investors the tools they need.
Overall though, it’s important to remember this is a nuanced area. For example, there is currently a lot of debate over whether charities should divest from oil majors. But at the same time, these companies are some of the biggest investors in ‘clean’ technologies such as wind farms and solar energy. So in fact, just selling these stocks doesn’t necessarily solve the problem of pollution. Wealth managers can help investors to explore these questions and find the right solutions for their personal needs and beliefs.
(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)