Ethical tracker funds offer low cost and sustainability. What’s not to like? Unfortunately, they are having trouble letting go of fossil-fuel holdings ethical investors will likely want to avoid.
They use out-of-the-box indices, cutting out active management and the higher fees that come with it. Two providers of such indices are MSCI and FTSE.
MSCI’s environmental, social and governance (ESG) tracking indices score companies on available ESG data, and will also screen out companies violating international norms or involved in controversial weapons, meaning those made illegal in international law. It says it rates credentials on thousands of data points across 37 ESG issues.
The FTSE4Good index uses stock market indices and research from charitable organisation Ethical Investment Research Services, to measure the performance of companies’ practices.
Although a deep dive into the ESG data on a company may be very revealing, funds tracking these ESG-based indices often end up with top holdings that could confuse the investor.
Not what they seem
Digital wealth management and advice firm Nutmeg recently launched a passive, sustainable portfolio range. It has a number of exclusions such as weapons, alcohol and pornography and makes use of UBS MSCI UK IMI Socially Responsible exchange-traded fund (ETF). But this fund also has mining company Rio Tinto as its top holding, and oil and gas company BP as its second top holding.
Legal & General’s Future World range has two ethical passives, but has Royal Dutch Shell as its second top holding.
The FTSE4Good index has HSBC as its top holding, followed by Royal Dutch Shell.
Tom McGillycuddy, founder of investment app tickr, believes, despite these funds using ESG ratings and screening methodologies, they will find clients saying: ‘that’s not what I meant by sustainable’ when they see the holdings.
Julia Dreblow, founding director of Fund EcoMarket, an ethical investment information hub for intermediaries, says there is a deeper issue with transparency, which some could see as downright misleading.
‘Passive funds should keep it very straightforward. They should have clear dos and don’ts, and not try to be an active fund,’ she says. ‘Trackers following ESG performance fall down because they put carbon on the same footing as executive pay when rating companies.’
Imperfect assumptions lurk behind the ESG data being generated, she says, as companies cannot realistically provide all the data required of them. ‘You end up working on assumptions on top of assumptions and, privately, those working in the sector will tell you the data does not match up between one index and another.’
End-investors are unlikely to dig to that level, but they do ask why their sustainable portfolios at Nutmeg are invested in BP, says Nutmeg chief investment officer Shaun Port.
He explains portfolios are significantly tilted towards sustainable, but entirely fossil fuel-free environmental portfolios would be too high risk at this point.
A more hopeful future
However, Port says sustainable investing will be the ‘mainstay’ of Nutmeg’s business in five years, as the market is growing and improving but not yet perfect.
‘We have been very clear with our clients: this is the starting point, and this is a journey,’ he says. ‘The asset classes will develop over time, broadening out the proposition. For example, we expect to get global high-yield bonds with an ESG format very soon. They will be easy to access and low cost.’
McGillycuddy’s start-up, tickr, offers clients a climate change themed fund that blends six to eight separate trackers, one of which is the iShares Global Clean Energy Ucits ETF, investing in clean energy companies. He says this is a fantastic product, but could not be used alone for tickr clients because, again, that would be too high risk.
McGillycuddy says there is a gap in the market for genuinely high-quality ESG trackers, so tickr will be building its own soon.
If these types of mass ethical market passives are a threat to active, it is to do with their lower cost and how investors use them.
Product providers using trackers for the ethical market know there is still a gap between what clients want and what is available. Until they can confidently bridge that gap, they should be wary of overstating their ESG credentials and make their investment methodologies and holdings as clear and easy to find as possible, or risk damaging trust.