The Rise of ESG ETFs

In part six of our ETF podcast series, Ropes & Gray attorneys Paulita Pike, Brian McCabe, and Ed Baer discuss the growth of ETFs that invest using ESG considerations.

Transcript:

Brian McCabe: Hello, and thank you for joining us today on this Ropes & Gray podcast. I'm Brian McCabe, a partner in the Boston office of Ropes & Gray. Joining me today are two of my colleagues from the asset management practice group, Paulita Pike, a partner in our Chicago office, and Ed Baer, a counsel in our San Francisco office. In this podcast, which is part of a series of podcasts on ETF issues, we will discuss the rise of ESG ETFs. First, we need to level-set. Ed, can you tell us exactly what E-S-G means?

Ed Baer: ESG stands for Environmental, Social and Governance. There really is no one overarching definition of ESG. Generally speaking, “Environmental” considers how a company performs as a steward of the environment, including things such as energy consumption, water management, pollution, and other material issues; “Social” looks at how a company relates to its employees, suppliers, customers and the communities where it operates; and “Governance” covers a company’s management, including executive pay, board composition, diversity, transparency and shareholder rights. What ESG attributes matter, how various ESG attributes should be weighted, and whether a particular issuer meets a set of ESG criteria are inherently subjective. Ultimately, ESG is in the eye of the beholder, and as we will discuss in more detail, disclosure is the key.

Brian McCabe: Okay. Let’s talk a little bit about the ESG investment imperative. Paulita, what are some of the public touchstones for ESG that might be of interest to an adviser considering offering ESG products?

Paulita Pike: Brian, the United Nations Principles for Responsible Investment have been one of the key drivers of the focus on ESG. The Principles, which are voluntary and aspirational, offer a menu of possible actions for incorporating ESG issues into investment practices. Signatories commit to act in the best long-term interests of their beneficiaries and to be mindful of the ESG issues that can affect the performance of investment portfolios, while also aligning investors with the broader objectives of society. Consistent with applicable fiduciary responsibilities, signatories commit to incorporate ESG issues into investment analysis and decision-making processes, and to promote acceptance and implementation of the Principles within the investment industry, among other things.

Closely related to the UN Principles are the UN’s Sustainable Development Goals (or SDGs). The five-part framework of the SDGs includes: (1) identifying outcomes; (2) setting policies and targets; (3) having investors shape outcomes; (4) having the financial system shape collective outcomes; and (5) having global stakeholders collaborate to achieve outcomes in line with the SDGs. There are a number of ETFs that invest in accordance with the UN Principles generally and the SDGs specifically.

Ed Baer: That’s really helpful. Are there some other sources of ESG inspiration?

Paulita Pike: Yes. In addition to the UN Principles and SDGs, ESG asset managers also participate in The Forum for Sustainable and Responsible Investment, which is a leading advocacy group advancing sustainable investing across all asset classes. Another source of ESG guidance comes from the Equator Principles, which consists of a risk management framework adopted by financial institutions that aids them in determining, assessing and managing environmental and social risk in projects, and is primarily intended to provide a minimum standard for due diligence and monitoring to support responsible risk decision-making. Still, others rely on specific religious principles, such as Sharia or Catholic values. Brian, can you talk about some of the ways managers attempt to manage and implement ESG portfolios?

Brian McCabe: Certainly. There are many different approaches to ESG investing, and the ICI’s white paper on Funds’ Use of ESG Integration and Sustainable Investing Strategies does a good job of describing them and seeking to implement a consistent taxonomy. For example, “sustainable investing” generally makes ESG factors a significant part of the fund’s investment thesis in seeking attractive returns. Some firms, including some sustainable investing firms, integrate consideration of ESG factors with consideration of traditional investment factors in their investment process. In contrast, “impact investing” targets investments in issuers whose use of proceeds, in the manager’s opinion, provide a measurable positive social and/or environmental impact. Many managers engage in “active ownership” by considering ESG factors in proxy voting decisions and/or seeking to use ongoing engagement and dialogue with management to drive positive change.

To build portfolios, managers employ different approaches. “Exclusionary screening” or “negative screening” excludes from the investment universe those companies, sectors or countries involved in activities that do not align with the moral values of investors or global standards around human rights, labor practices, the environment and anti-corruption. “Positive screening” tilts a portfolio toward one of the following: best-in-class companies outperforming peers in ESG measures; ESG momentum companies improving ESG measures more quickly than peers; or thematic companies solving specific ESG challenges, such as climate change or gender diversity.

Ed Baer: Thanks for that explanation, Brian. As I noted before, disclosure is often the key. For managers, it is important that they clearly delineate their ESG investment philosophy and practices in disclosure documents. The SEC’s disclosure staff will examine disclosure about proposed ESG management practices to ensure that the disclosure clearly defines an ESG investment approach, and the SEC’s examinations staff will examine actual portfolios to make sure the portfolios are consistent with that disclosure. To avoid complications with the SEC, managers should make sure that they live up to the expectations they have set for themselves. But funds’ disclosures are not the only ESG disclosures that will be scrutinized. Paulita, can you talk about how issuers’ disclosures about their ESG attributes, efforts, impacts and risks are evaluated by managers?

Paulita Pike: Sure thing. One of the challenges that managers face is how to evaluate issuers on ESG measures. In an effort to provide a consistent framework for evaluating issuers, the “Big Four” accounting firms collaborated with the World Economic Forum and the International Business Council to produce a white paper titled >Measuring Stakeholder Capitalism: Towards Common Metrics and Consistent Reporting of Sustainable Value Creation. The white paper established a four-pillar framework focused on: (1) principles of governance; (2) the planet; (3) people; and (4) prosperity. The hope is that this disclosure framework will help asset managers evaluate investments on more than just traditional measures like earnings, P/E ratio and the like.

And it appears that these efforts may actually be taking hold. A recent survey by Natixis found that three-quarters of professional investors consider ESG factors to be an integral part of sound investing and an important way to better align investments with investor and organizational values.

Ed Baer: Brian, can you talk about how the SEC has begun to scrutinize ESG investing?

Brian McCabe: Sure. In recent months, the SEC and its staff have made a number of pronouncements regarding ESG investments. The agency is assessing disclosures, trading patterns, policies and procedures, and whether a firm’s or fund’s ESG-related activities live up to its disclosures. For example, the SEC recently created an enforcement task force on climate and ESG issues. The SEC also recently announced the appointment of a senior policy adviser for climate and ESG, placed an emphasis on climate and ESG in examinations and ramped up its review of corporate disclosures around climate risk. In addition, the recently-confirmed SEC Chair, Gary Gensler, has indicated his backing for increased climate disclosures. In February, the SEC's Office of Investor Education and Advocacy issued an investor alert to educate investors about ESG Funds.

More recently, the Division of Examinations released an ESG risk alert to highlight observations from recent exams of investment advisers and funds offering ESG products and services. The Division will be focusing on whether advisers and funds are accurately disclosing their ESG investing approaches and have adopted and implemented policies, procedures, and practices that track with those ESG-related disclosures. Particular areas of focus will include portfolio management policies, procedures and practices, performance advertising, and marketing and compliance programs.

Ed Baer: There certainly has been extensive focus on ESG by the SEC. But not everyone is so sure whether the SEC’s focus on ESG will result in actual policy changes. The SEC’s two Republican members, Hester Peirce and Elad Roisman, have questioned whether the agency was breaking new ground or simply putting a climate overlay on ongoing corporate and investment adviser disclosures. More recently, in response to the Division of Examinations’ ESG Alert, Commissioner Peirce attempted to clarify that despite the spate of recent SEC pronouncements, the SEC staff will not impose new obligations on registrants. Noting that “a firm’s disclosures about its personnel should match the reality” and that “compliance personnel in an ESG firm should be familiar with the firm’s business so that they can build and operate an effective compliance program for the firm,” Commissioner Peirce attempted to reassure investors and managers that the SEC staff’s focus should not create new obligations with respect to ESG investing. Brian, what is the Department of Labor doing these days with respect to ESG?

Brian McCabe: DOL rules announced late in the former administration implemented restrictions on what can and can’t be included in company 401(k) plans and provided guidance regarding proxy voting by ERISA plan fiduciaries. The new rules would have prevented plans from using funds with nonfinancial goals (such as ESG goals) as default investments and prevented plan fiduciaries from exercising proxy voting rights for non-financial reasons (for example, to advocate for social or governance results that don’t generate economic value). However, in March, the DOL’s Employment Benefits Security Administration announced that it will not enforce those recently published final ESG-related rules. So, there’ll be more to come from the DOL.

Ed Baer: Okay. Well, this is an ETF Podcast, and so far we haven’t spent much time talking about ETFs. So how does all this talk of ESG investing tie into ETFs? ETFs may be the ideal vehicle for ESG investing. Investors have plenty of experience using ETFs as exposure vehicles to express views on certain investing ideas. The rapid growth of ESG ETFs is giving investors the tools to express their “green” views in a low-cost, efficient, tax-friendly manner. And ETF sponsors have heard the message that investors want these products. According to a recent ETF Investor Survey conducted by Brown Brothers Harriman, 72% of global ETF investors plan on raising their ETF allocation over the next year, with a focus on thematic, ESG, and semi-transparent active ETFs. Survey respondents indicated that in five years, 56% of ETF investors expect to have at least 11% of their portfolios invested in ESG ETFs. According to a different survey, 61% of financial advisors revealed they were using ESG-related products.

ESG ETFs also attracted significant assets in 2020. Globally, a record $89 billion flowed into ESG ETFs in 2020, well above the $28 billion of flows in 2019. ETFGI recently reported that ESG ETFs listed globally have gathered net inflows of nearly $56 billion year-to-date, and total assets invested in ESG ETFs now exceeds $246 billion globally. There are now over 100 ESG ETFs in the U.S., including equity and fixed income products, with assets well over $30 billion.

Brian McCabe: And things may only be getting better for ESG ETFs. iShares recently launched two ESG ETFs that raised nearly $2 billion in the first day of trading. Paulita, with all this activity, what are you hearing from clients and fund boards about ESG ETFs?

Paulita Pike: Boards that we work with are hearing a lot from fund sponsors about the growing demand for ESG products, and they are educating themselves. Sponsors we work with are conducting research and working to develop new ETF products to satisfy the growing client demand for ESG ETFs. Given the client and regulatory focus on ESG investing, we think clear disclosure is key, as is operating ESG portfolios consistent with those disclosures, and boards are focusing on that dynamic. Sponsors should be making sure that they have policies and procedures in place to monitor their ESG investments and disclosures, and should be prepared to answer the SEC’s questions about ESG investing if they are subject to an examination.

Ed Baer: That brings us to the end of the podcast. Paulita, Brian and I want to thank all of you for joining us on this discussion of ESG and ETFs. For more information on the topics that we’ve discussed or other topics of interest to asset managers and ETF sponsors, please visit our website at www.ropesgray.com, where we have links to some other additional material regarding these topics. To help you better understand the current ETF landscape, we will be issuing several additional podcasts designed to provide a greater depth of analysis on important and timely ETF issues. If you have any questions regarding the topics we addressed or anything else, please don't hesitate to get in touch with one of us or whomever you have a working relationship with at Ropes & Gray. You can also subscribe and listen to the series of podcasts wherever you regularly listen to podcasts, including on Apple and Spotify. Thank you again for listening.