How to choose an ESG ETF

By Sefian Kasem, senior ETF investment strategist, HSBC Global Asset Management

Selecting an ESG exchange-traded fund (ETF) requires careful consideration. Investors are spoiled for choice, and choosing the right ETF can entail trade-offs in terms of the ESG improvement an investor is looking to achieve and the risk characteristics of the fund they ultimately invest in.

There are many different ways to screen companies depending on the ESG framework employed. Looking at ESG scores can be a catch-all for a large swathe of considerations. Investors can also drill down into these scores in their research, looking at their propensity to pollute, their health and safety procedures or how they treat their employees, for instance.

What should investors consider when selecting a fund with an ESG filter embedded within it? To answer that question, investors first need to define their philosophy by addressing the following:

1. Do I want specific ESG factors or do I invest in a fund that targets all of the most important ESG considerations in one go?
2. If it is the former then investors should consider a number of smaller building blocks which target granular E, S or G considerations.
3. If it is the latter, investors should focus on funds that capture ESG considerations in a holistic manner such as through an aggregated ‘ESG score’.
4. If investors want a bit of both, a screening process based upon ESG scores with other more granular filters can be designed.

ESG filters aside, there exist ESG products that provide exposure to specific themes. These are defined as individual issues that can potentially be solved with funding – clean water and clean energy, for example.

What’s more, ESG funds can be designed to embed certain regulatory criteria into their methodologies, such as a decarbonisation trajectory aligned to the Paris Agreement, which is aimed at ensuring global warming is limited to below 2°C over the coming decades.

In short, there are many ways to embed ESG criteria into a fund and numerous approaches exist in the market.

By employing a calibrated combination of exclusions and tilts, ETF providers can attempt to incentivise companies to change their behaviour. If they fail to do so this could impact their funding, as investors shy away from companies with weaker ESG credentials, and indeed the worst offenders may be excluded altogether.

This sends a strong signal to companies with poor ESG attributes, while at the same time giving them the opportunity to improve their practices and be rewarded for their efforts. ETF providers can also choose to engage where possible.