Core exposures incorporating ESG criteria
Much of the recent interest, especially in the ETF space, has been for ESG alternatives to core equity exposure. Most ESG investors want a fund that at the very least excludes “undesirable” companies and many may also want the fund to favour companies that are performing well from an ESG perspective. While the specific exclusions may vary and funds can apply a variety of positive screening strategies, what is now more consistent is that most investors also have an expectation for financial performance. In many cases, this is for the fund to have a similar risk and return profile as a broad nonESG index.
You just need to look around the market to see a notable increase in the availability of portfolios constructed entirely of ESG funds, whether through advisory or a direct robo platform. And wealth managers and financial advisers can reduce total portfolio costs substantially by investing in passive ETFs. The good news for financial advisers and clients alike is that there are now an increasing number – and variety – of ETFs offering targeted exposure to most of the main asset classes.
US equity exposure with improved ESG scores plus potential performance advantage
For example, the S&P 500 index is the most widely followed benchmark for US large-cap exposure. Given that this bucket could account for as much as 40% of some globally diversified growth portfolios, your choice of exposure can make a huge difference in terms of overall portfolio performance. But how can you get exposure to the S&P – or at least the potential for similar performance – with ESG criteria?
The S&P 500 ESG index has been designed to do just that. Back-tests suggest that the risk and return profile of the ESG index could be similar to the broader S&P index, with similar sector exposures, but with a substantially improved ESG score. As we’re talking about passive exposure, it’s important to understand the index and how it’s constructed. First of all, the index excludes companies involved in tobacco or controversial weapons, as well as those with poor ESG records. Once all those names are removed, the index selects the companies with higher ESG scores in their industry group, selecting stocks until they cover 75% of the industry group market cap.
The result is a market-cap-weighted index of currently 311 stocks, each an industry leader in ESG, which has similar sector exposures to the broad index. We recently launched an ETF that aims to deliver the performance of this index, less a very low ongoing charge figure of 0.09% per annum. We expect the ETF to appeal to a broad range of investors but particularly those who want S&P performance potential but with better ESG scores.
What could make this ETF even more attractive for investors who are really interested in performance is in the way the ETF replicates the index. This ETF holds a basket of high-quality securities and aims to achieve the index performance through swaps (a type of derivative whereby the swap counterparties agree to pay any difference between the return of the basket and that of the index). While the basket of securities will differ from the index, we are applying the same key exclusions to the basket as the index.
So, why not just replicate the index in the “normal” way? By using this replication method, the ETF is able to capture gross dividends, with no withholding tax, which offers a potentially significant advantage over physically replicating ETFs that are subject to dividend withholding tax of between 15-30%. This is specific to the US equity market and is one of the reasons why our standard S&P 500 UCITS ETF – which uses the same proven replication method – was the most popular S&P 500 ETF in Europe last year.
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