The world of investing is evolving quickly as more people become aware of their impact on the planet and seek ways to align their financial choices with their values. One of the most accessible and popular methods for sustainable investing today is through sustainable exchange-traded funds (ETFs). With a unique ability to balance profit and purpose, sustainable ETFs offer investors an opportunity to make a positive difference while pursuing financial goals. In this article, we’ll explore what sustainable ETFs are, why they matter, and how you can incorporate them into your investment strategy.
What Are Sustainable ETFs?
To understand sustainable ETFs, it’s essential to first know what an ETF is. An exchange-traded fund (ETF) is a type of investment fund that holds a collection of assets like stocks, bonds, or commodities and trades on an exchange, much like a stock. ETFs offer an accessible and diversified way for investors to participate in the market without needing to buy individual stocks.
Sustainable ETFs, also known as ESG ETFs, are funds that select assets based on specific environmental, social, and governance (ESG) criteria. These criteria ensure that only companies meeting certain ethical standards are included, focusing on sustainability and social responsibility. Sustainable ETFs allow investors to support companies that actively prioritize the well-being of the planet and society while maintaining competitive financial performance.
The Rise of ESG: Understanding Environmental, Social, and Governance (ESG) Criteria
One of the core components of sustainable ETFs is their adherence to ESG criteria. ESG refers to three central factors that measure the ethical impact and sustainability of an investment. Here’s a quick breakdown:
- Environmental: This aspect considers how a company impacts the environment, including carbon emissions, energy use, waste management, and water conservation.
- Social: Social criteria examine a company’s relationships with employees, customers, and communities. This can include labor practices, employee diversity, and community engagement.
- Governance: Governance looks at how a company is led and managed. It assesses aspects like board diversity, executive pay, shareholder rights, and transparency.
ESG criteria help investors identify companies that prioritize ethical practices. While ESG is the most common approach to sustainable investing, you may also encounter other terms like Socially Responsible Investing (SRI) and impact investing. SRI screens out certain “sin stocks” (like tobacco or weapons), while impact investing seeks investments that deliver measurable social or environmental benefits alongside financial returns.
Benefits of Investing in Sustainable ETFs
Investing in sustainable ETFs offers numerous benefits, not only for the planet but also for investors looking to achieve long-term gains. Here are some of the main advantages:
1. Financial Growth with Ethical Alignment
Sustainable ETFs allow investors to align their portfolios with their values, choosing companies committed to environmental and social progress. This approach offers a way to contribute positively without sacrificing potential returns.
2. Support for Positive Change
By investing in companies that prioritize sustainable practices, investors can help direct more capital toward sectors that focus on renewable energy, conservation, and social equity. Over time, this influence encourages more companies to adopt sustainable business practices.
3. Portfolio Diversification
Sustainable ETFs cover a range of industries, from clean energy to technology to green real estate. This variety allows investors to diversify their portfolios across multiple sectors and reduce risk.
4. Resilience in Volatile Markets
Research suggests that companies with strong ESG practices often show resilience during economic downturns. Companies with sustainable operations and good governance may better weather regulatory changes, reputational risks, and market volatility.
5. Cost efficiency of sustainable ETFs
Sustainable ETFs can be a cost-efficient vehicle to replicate an ESG index. Compared to actively managed funds, ETFs are priced significantly lower. The total expense ratio (TER) usually is between 0.03% for e.g. an ESG screened S&P500 ETF up to 0.60% for a thematic or sector ETF.
Types of Sustainable ETFs Available in the Market
Sustainable ETFs cover various themes and sectors, offering choices for investors with different goals and interests. Here are some of the popular categories:
ESG screened broad market ETFs
ESG screened broad market ETFs aim to replicate an index such as the MSCI World or the S&P 500 but apply an ESG filter on top. ESG screened ETFs tend to hold fewer holdings than the broad market index as exclusions are applied (e.g. controversial weapons, nuclear weapons, tobacco, fossil fuel extraction etc.).
Clean Energy ETFs
These ETFs invest in companies focused on renewable energy sources like wind, solar, and hydroelectric power. They include popular funds like the iShares Global Clean Energy ETF, which tracks companies involved in clean power production.
Green Technology ETFs
Green tech ETFs focus on companies developing innovative technologies to reduce environmental impact. This includes firms working in energy efficiency, waste reduction, and emissions control.
Water Management ETFs
Water is a critical resource, and ETFs like the Invesco Water Resources ETF invest in companies that manage, purify, and conserve water, an area expected to grow due to global water scarcity issues.
Social Responsibility ETFs
These funds may focus on companies with strong labor practices, gender diversity, and fair compensation policies. For example, the SPDR SSGA Gender Diversity Index ETF focuses on firms with high levels of gender diversity in leadership.
Governance-Focused ETFs
Some ETFs emphasize governance aspects, such as board structure and transparency. This focus often appeals to investors interested in ensuring ethical leadership within companies.
Case Study: MSCI World Index vs. MSCI World ESG Screened Index
The MSCI World ESG Screened Index excludes companies based on specific environmental, social, and governance (ESG) criteria. While the exact list of excluded companies is dynamic and subject to change, the primary exclusion categories include:
- Controversial Weapons: Companies involved in the production or distribution of controversial weapons, such as cluster munitions, landmines, and biological or chemical weapons.
- Nuclear Weapons: Entities engaged in the manufacturing or distribution of nuclear weapons or related components.
- Civilian Firearms: Companies producing firearms and small arms ammunition for civilian markets, or those deriving significant revenue from their distribution.
- Tobacco: Firms classified as producers of tobacco products or those generating substantial revenue from tobacco-related activities.
- Fossil Fuel Extraction: Companies deriving 5% or more of their revenue from thermal coal mining and unconventional oil and gas extraction.
- Thermal Coal Power: Companies deriving 5% or more of their revenue from thermal coal-based power generation.
- UN Global Compact Non-Compliance: Companies failing to comply with the United Nations Global Compact principles.
- Severe ESG Controversies: Companies involved in very severe ESG controversies, including those related to environmental degradation, human rights violations, or corruption.
These exclusion criteria are detailed in the MSCI ESG Screened Indexes Methodology.
Due to these exclusion criteria, several prominent companies are typically omitted from the MSCI World ESG Screened Index. Examples include:
- ExxonMobil Corporation: A major oil and gas company involved in fossil fuel extraction.
- Philip Morris International: A leading tobacco producer.
- Lockheed Martin Corporation: A defense contractor associated with the production of controversial weapons.
- British American Tobacco: Another significant tobacco company.
- Northrop Grumman Corporation: Engaged in the manufacturing of defense systems, including controversial weapons.
As of September 30, 2024, the MSCI World ESG Screened Index had 1,294 constituents, compared to 1,410 in the standard MSCI World Index. The top holdings in the ESG Screened Index included companies like Apple, Microsoft, and NVIDIA, reflecting a higher concentration in technology sectors.
How to find sustainable ETFs for your portfolio?
Given the popularity of sustainable investing, the offering of sustainable ETFs has increased significantly over the past few years. Almost all ETF and fund comparison tools have introduced functionalities to filter for sustainable product.
A popular way to get a first analysis of your selected fund or sustainble ETF is the ESG Fund Ratings and Climate Search Tool which is offered by MSCI.
The tools will analyze your ETF along the following five dimensions:
- How well is the fund aligned to global climate goals?
- How is the fund currently exposed to climate transition risk and opportunities?
- What is the impact of environmental, social and governance (ESG) issues on the fund?
- How aligned is the fund with best practices on board independence and diversity?
- Is the fund exposed to companies involved in business activities that some investors avoid?
The ESG Fund Rating tool of MSCI helps you to get a good understanding about how well your selected ETF is set up in terms of sustainability. By comparing different sustainable ETFs, you can find the ones which are the best match for your sustainability objectives.
The Future of Sustainable ETFs
The demand for sustainable ETFs shows no signs of slowing down. With climate change and social issues becoming increasingly urgent, investors are driving demand for companies that prioritize sustainability. In response, more companies are adopting ESG principles, and regulators worldwide are discussing new policies to promote transparency in sustainable investing. More information on the topic can be also found in our Insights Article “Sustainability Synonym and ESG Investing“.
The future may bring even more specialized sustainable ETFs, covering areas like biodiversity conservation and waste reduction. As these funds become more prevalent, they will likely continue to influence corporate behavior, encouraging businesses to adopt more ethical practices to attract investment.
Conclusion
Sustainable ETFs offer a compelling way to invest in the future while staying true to your values. By choosing ETFs focused on environmental, social, and governance principles, investors can make a positive impact and contribute to a more sustainable world. Whether you’re a seasoned investor or just starting, sustainable ETFs provide an accessible route to support ethical and profitable companies.