The Sustainable Exchange-Traded Universe Continues to Expand – Morningstar.com

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When I took stock of the universe of sustainable exchange-traded products at this time last year–just ahead of the Morningstar ETF Conference–I noted the rapid increase in the number of diversified equity offerings pursuing sustainable investing, meaning they incorporate environmental, social, and corporate governance considerations in their investment processes. A year ago, 20 such funds existed, 17 of them having been launched in 2015 or in the first eight months of 2016. Together, they totaled $1.9 billion in assets.

Fast forward a year and we’ve seen an additional 13 launches (and one closure), bringing the total number of sustainable diversified equity ETPs to 32. Thirty of those are ETFs, and two are exchange-traded notes. As of July, their assets totaled $3.1 billion. I expect this universe to continue growing because of the confluence of interest in both sustainable investing and low-fee passive investing among institutional and retail investors.Notable additions this year include Nuveen’s NuShares ESG series, which draws on Nuveen parent TIAA’s long-standing experience with passive ESG investing and is offered in five U.S. style-box versions. The funds focus on ESG leaders in each sector, and the portfolios are fossil-fuel-reserves free and have low carbon footprints relative to their indexes. Investors could use these funds to set their market-cap and style exposures in the U.S. equity portion of their portfolios. In a similar vein, ClearBridge launched two large-cap style-focused ETFs:  ClearBridge Dividend Strategy ESG ETF and  ClearBridge Large Cap Growth ESG ETF . State Street Global Advisors built out their fossil-free ETF lineup this year, launching  SPDR MSCI EAFE Fossil Fuel Free ETF and  SPDR MSCI Emerging Markets Fossil Fuel Free ETF to complement  SPDR S&P 500 Fossil Fuel Reserves Free ETF , which launched in late 2015. Investors can combine them for global fossil-free equity exposure. Note, however, that these funds simply remove companies with fossil-fuel reserves from a standard index portfolio, and don’t otherwise incorporate ESG considerations. That’s why they have generally average Morningstar Sustainability Ratings. Many other sustainable offerings are both fossil-free and use ESG criteria. Finally, Van Eck launched  Van Eck Vectors Green Bond ETF , the first sustainable bond ETF and one that offers a way for investors to gain access to green bonds, which finance environmental and climate-related projects. The universe still lacks a more broadly based fixed-income option.With plenty of sustainable ETF options on the equity side, investors can now use them to build out diversified portfolios. In so doing, however, they face several challenges. The first is the lack of established track records. Only three of the 30 ETFs have three-year records; most haven’t even hit the two-year mark. Early returns look decent, but it’s really too early to tell. Keep in mind, though, these are passive funds that track indexes, so it’s worthwhile to look at the underlying indexes for clues as to how the funds will perform. If an underlying index has a longer record–not always the case, because indexes are often created just prior to an ETF being launched to track them–you can assume the fund’s performance would have been similar, minus expenses. If the underlying index is the same age as the fund, there may be a back-test of some sort. Back-tests can provide insight into an ETF’s likely performance but should be taken with a grain of salt because no ETF has ever launched based on a poorly performing back-tested index.

A second issue is asset size. While their ranks have been growing and AUM is up about 65% from this time last year, most sustainable ETFs are small and remain well below the size necessary to be viable over the long run. Only eight funds currently have assets greater than $50 million. This is a concern, because persistently low AUM puts an ETF at risk of closure. Because the growth of investor interest in ESG still seems to be in the early stages, I would expect that most recently launched ETFs will be given time to establish viable performance records and to attract assets on that basis. It’s worth considering who the issuer is, as those with greater ETF and sustainable investing experience and deeper pockets may have more patience in letting their funds get to scale. 

Finally, there are fees. For years, iShares has charged 0.50% for the two oldest and largest diversified ESG ETFs:  iShares MSCI KLD 400 Social ETF and  iShares MSCI USA ESG Select ETF . In a world where low fees reign, and where an S&P 500 ETF costs a scant 0.04%, it’s increasingly hard to sell yourself or a client on a U.S. large-cap ESG ETF that costs 12.5 times more. That difference, 46 basis points in this case, is more than enough to offset DSI’s performance deficit versus an S&P 500 ETF. During the trailing 10 years through June 30,  iShares Core S&P 500 ETF gained an annualized 7.13%, which was just 26 basis points better than that of DSI’s 6.87% annualized gain. Fees are coming down. Several of the new U.S. large-cap offerings are charging 0.35%, and fossil-free and low-carbon offerings, which don’t consider broader ESG issues, charge 0.20%. Just this month, BlackRock slashed the fees on three of their sustainable investing ETFs: iShares MSCI USA ESG Optimized ETF now costs 0.15%, down from 0.28%; iShares MSCI ESG Optimized ETF now costs 0.20%, down from 0.40%; and  iShares MSCI EM Optimized ETF now costs 0.25%, down from 0.45%.

The universe of sustainable diversified ETFs is relatively new, small, and expensive when compared with conventional diversified equity ETFs. You can adjust for short performance records by examining the longer records of the indexes upon which a fund is based. If you are considering a small fund, take a look at the issuer and how well it is established in the ETF and sustainable investing spaces. Investing with better-situated issuers increases the odds that the fund will grow to scale and remain open. Focus on ETFs with expenses of 0.35% or less. They are more likely to perform better and grow assets. You can still play it safe by paying 0.50% for DSI or SUSA, purchasing the comfort of their size and established performance records, but their records might also be considered proxies for the smaller, newer, and cheaper sustainable ETFs now available. If DSI and SUSA were able to provide competitive performance over the long run at 0.50%, newer funds based on similar kinds of indexes and charging investors less could do just as well. 

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