European sustainable ETF flows surpass all others for first time

Inflows into self-proclaimed “sustainable” exchange traded funds overtook those into all other ETFs for the first time in Europe in the first quarter of the year.

The finding caps an extraordinary rise for ETFs that claim to invest according to environmental, social and governance (ESG) principles, which recorded exponential growth globally in 2020 with assets jumping three-fold from $59bn to $174bn, according to data from TrackInsight.

Flows accelerated still further in the first three months of this year, with the record $25.8bn taken in by ESG ETFs in Europe exceeding the $22.3bn collected by non-ESG ETFs for the first time, according to data from Morningstar. As recently as 2019 ESG ETFs accounted for just a sixth of new money.

“There has been a significant increase in flows into ESG products in the last two quarters, and this is expected to continue, supported by new money and by a rotation from non-ESG investments into ESG alternatives,” said Jose Garcia-Zarate, associate director, passive strategies research at Morningstar.

“A lot of investors, whether it’s by virtue of preference or regulatory pressures, are going into sustainable investing. ESG is becoming the new normal. We are at the beginning of this journey,” he added.

As a result of the surging inflows, the assets of ESG ETFs have now risen above 10 per cent of the overall ETF market in Europe for the first time, the Morningstar data show.

The picture looks quite different in the US, where ESG ETFs accounted for just $7.6bn, or 3.1 per cent, of the record $248bn that gushed into all ETFs in the first quarter of the year.

However, there are some signs of “sustainable” investing starting to make some headway there, with the BlackRock US Carbon Transition Readiness ETF breaking the record for first-day inflows for any ETF when it took in $1.25bn earlier this month.

Amin Rajan, founder of Create Research, a consultancy, said there were structural forces at play which made him believe ESG ETFs would continue to see rapid growth.

Not least is the fact that the performance of ESG index funds “held up well in the last bear market in March last year”.

“Before then ESG was seen very much as a bull market luxury,” Rajan said. “[People worried] how they were likely to fare in a market correction, and that question was answered with ESG funds performing much better than anyone expected, including me. They have really stood the test of time.”

However, Rajan said the possibility remained that the strong showing of ESG funds could simply be a cyclical momentum trade, with favoured stocks and funds chalking up strong gains just because so many people are buying into them at the same time.

“There is so much interest in [ESG funds] it’s difficult to know how much of [the outperformance] is due to the improvements in the ESG ratings of these [funds’ holdings] and how much is simply a bandwagon effect,” he argued.

“I’m inclined to believe it’s not the latter, but I would not rule that out.”

Garcia-Zarate said he had seen cases of investors switching from ETFs tracking traditional market indices to the those benchmarked against their ESG version, even if at times there was not a significant difference between the measures.

The ESG variant of the S&P 500, for instance, has the same five top holdings as the mainstream version — Apple, Microsoft, Amazon, Facebook and Alphabet — with Tesla, known for its ability to split opinion as to its ESG-ness, the largest stock omitted.

The ESG version’s carbon-to-value invested metric is only 21 per cent lower than for its parent index, and the ESG index actually has 13 per cent higher fossil fuel reserve emissions.

“I can’t see a substantial difference between them,” said Garcia-Zarate.

Rajan also had concerns as to how much difference ESG investing was really making, given that the raw company-by-company data that rating agencies base their decisions on is “self-reported, self-serving and voluntary”.

“Are companies improving their carbon footprint? There is so much greenwashing. I don’t know if there are many governance improvements going on. Best to keep an open mind.”

Whatever the truth, Garcia-Zarate said most ETF product launches, whether equity or fixed income, now had an ESG angle, a trend that was only likely to intensify.

A desire to attract greater assets might not be the only motivation behind this trend, though, suggested Peter Sleep, senior portfolio manager at 7 Investment Management.

“Why not if you can charge a bit extra for the green label at the moment?” he said. “Pretty soon the ESG premium will be competed away.”

As to whether the ESG tide is now unstoppable, Garcia-Zarate said it would ultimately come to a halt “because if the whole market goes in that direction the whole market will be ESG, and then it means nothing. The nature of the market will have shifted.”

“Maybe in a few years’ time we don’t need to know [funds] are ESG because everything is ESG compliant,” he added.

As to what that means for legacy non-ESG products, Garcia-Zarate said he had “put that question to ETF providers”. 

“If they think that ESG is the way forward, then why do they keep on selling the non-ESG versions?” he asked. “At the moment there is no definitive answer, rather than ‘we’ll just see how demand goes’.”