ETFs for the transition to a more sustainable economy

Contrary to 2023’s apparent ESG backlash, flows into sustainable funds globally continued to outpace the rest of the fund universe. This trend included ETFs where Europe led the way with $40bn of net flows into Sustainable ETFs.¹

While the debate over ESG isn’t going to disappear, the fact remains that environmental, social, and governance-related risks are  some of the most significant threats businesses face, while ongoing regulatory moves and consumer demand continue to strongly incentivise corporates to meaningfully address ESG issues at the core of their practices.

The transition to a more sustainable economy offers a wealth of potential investment opportunities. While sustainable investing returns have been under pressure recently as geopolitical events have been a drag on performance, longer-term, choosing the right sustainable investing approach remains key to allocating capital - one that not only delivers a financial return but also supports the transition to a lower carbon economy. 

For ETF investors, there has never been more choice in terms of how to achieve this and there is no one-size-fits-all when it comes to sustainable investing. Significant developments in product innovation across the ETF industry in recent years include the emergence of active management and the launch of fixed income ETFs, which both offer new routes to ESG integration via the potential benefits of an ETF wrapper. 

Most focus on the ‘E’

When it comes to ESG – the ‘E’ (environmental pillar), has so far been the focus for most investors and we believe this will continue to be the case for the foreseeable future.

One of the most dominant investment themes over recent years has been around decarbonising portfolios. The other area we see an investment case for is biodiversity and one of our convictions at AXA IM is that we cannot address climate change without simultaneously addressing biodiversity loss.

The challenge for investors is choosing between the myriad of ways to integrate environmental considerations into portfolios. The current ETF landscape offers investors the ability to allocate through regional building blocks as well as via global strategies in both equities and fixed income. As always, the right choice will depend on individual investment goals but in our view, there are two potential options worth considering: thematic ESG ETFs and ETFs either tracking or managed in reference to a decarbonisation benchmark.

Thematic ESG ETFs

Thematic ESG ETFs focus on specific sustainability themes; for example clean energy, sustainable food or gender equality. The rise of active ETFs has opened the ETF world to thematic investing and is particularly key when it comes to sustainability.

Active managers can research companies and issuers and have the flexibility choose whether to expose their portfolio to the potential risks or opportunities they identify. This allows portfolio managers to act on conviction with the aim of providing both positive, measurable impact on the environment and financial returns.

Thematic ESG ETFs offer investors the chance to focus on the topics of climate and biodiversity and can be used either as building blocks for a core portfolio or as a satellite allocation to access environmental themes.

Decarbonisation benchmarks

As ETFs have historically been used predominately for passive equity, there was limited scope for ESG integration. Investors seeking to incorporate environmental issues into their portfolios usually focused on active mutual funds due to the inability of index strategies to select individual securities based on sustainability criteria.

That said, index approaches to environmental issues have existed for some time but improvements in data quality, combined with the integration of comprehensive climate index labels by regulators, mean ETF investors are now able to use index investing to reflect carbon-related goals in their portfolios more effectively.

Decarbonisation indices – such as Paris-Aligned Benchmarks (‘PABs’) - are designed for investors looking to decarbonise their portfolios while achieving a return on their investment, through either active or passive approaches. The role of a decarbonisation index is to closely track its parent index while sifting out issuers that don’t meet the emission requirements. Therefore, a decarbonisation index will have less issues than its parent index, although it still maintains sufficient diversity and liquidity.

Historically, funds looking to reflect decarbonisation in their portfolios would use a standard benchmark and then exclude certain sectors. This led to higher tracking errors because the exclusions meant a more concentrated portfolio. Being able to use a benchmark specifically designed to reflect companies that are contributing towards decarbonisation should mean a fund’s tracking error is much lower.

Plenty of options for ETF investors

The ETF landscape is growing fast and while it has mainly been a passive equity story so far, we are seeing increased demand for products such as active, thematic, and fixed income ETFs. Innovative ESG solutions combining the aspects of sustainability and performance are increasingly in demand.   

It is not a binary active or passive discussion though. Depending on required exposure, there could be a role for an actively managed approach, something completely passive, something in the middle that has a tilt to active but limits the tracking error, or a combination. What’s encouraging is the choice now available to ETF investors seeking more sustainable solutions.