What are ETFs?

An ETF stands for Exchange-Traded Fund, which are baskets of stocks and bonds that are invested into the stock market, typically replicating the performance of an index. In short, ETFs are investment vehicles which allow investors to buy into many companies in a single share. Compared to mutual funds, ETFs are favoured by investors because of their significant advantages: low cost to invest, low values to invest, increased diversification and an overall ease of trading.

What are ESG ETFs? And what makes them different to ETFs?

ETFs help to simplify investing, and the hope is that ESG ETFs will make sustainable investing as simple as traditional investing. Just like standard ETFs, ESG ETFs allow investors to achieve diversification in their portfolio, however what makes them stand out is their ability to target companies that satisfy specific ESG criteria.

The inherent characteristic of an ETF is the passive nature of the fund, insofar that they generally match the performance of a benchmark such as an index or a specific sector. To best understand the characteristics of an ESG ETF however, it’s crucial to know about their other active and smart beta natures:

  1. An active ETF’s primary aim is to beat the performance of the benchmark.
  2. A smart beta ETF is a blend of active and passive, as the fund follows both the performance of an index and considers alternative factors.

An ESG ETF is either active or smart beta. Currently, the market is shifting away from passive ETFs towards a future where active or smart beta will saturate investors’ strategies (cf. 1). A report conducted by Aberdeen Standard confirms this trend, stating that 21% of investors plan to boost their allocation to smart beta ESG. Smart beta ESG is capable of forming part of core investment allocations, whereby investors’ needs for both a positive return and ESG governance are fulfilled.

Figure 1: The Transition from Passive ETFs between 2017 and 2023 (J.P. Morgan)

Growth & Projection of ETFs

The first ETF was founded in 1993 and has since seen significant growth, significantly spurred on by the 2008 financial crisis which made it a popular product among investors, sparking an exponential 25% average annual increase (cf. 2). Global assets held by ETFs reached $7 trillion in September 2020 and Bank of America has predicted that the ETF market will be worth $50 trillion by 2050.

Figure 2: The Growth in Assets of Global ETFs (Statista)

With an increase of $10 billion AUM (+168.4%) between 2018 and 2019, iShares was the biggest issuer. A report by Moody’s Investors Services describes ESG investing as a value proposition which investors can deliver, promising consistent financial performance. Europe, renowned for being a leader in Responsible Investing, have demonstrated great faith in ESG ETFs, which represent 100% of European equity ETF market inflows since the beginning of 2020. According to Bloomberg, the value of AUM of European smart beta ETFs reached €69 billion at the end of 2019, and an additional €33 billion was invested in ESG strategies. As the number of ESG ETFs have risen over the years, so has their volume of AUM (cf. 3).

Figure 3: Relationship between the global growth of ESG ETFs available and the growth of ESG ETF’s AUM (TrackInsight)

The projected growth of ESG ETFs (cf. 4) reflects the growth that we have seen in the past decade; that’s to say, exponential. Brown Brothers Harriman expect that in five years, 30% of global ETF investors will have between 11% and 20% of their portfolio in ESG ETFs. This would not come as a surprise, when within ESG ETF’s first week of trading, the iShares ESG MSCI EM Leader ETF attracted more than $600 million, the biggest debut of any US ETF in 2020.

Figure 4: Projected Growth of ESG ETFs (in Billions $) (TrackInsight)

All the aforementioned data illustrates an optimistic future for ESG ETFs with, in particular, JP Morgan’s consumer research confirming this, showing that respondents expect around 40% of their portfolio’s ETF allocation to be within either active or smart beta ETFs. However, to ensure that such promising growth continues, ETFs must heavily rely on gaining traction within emerging economies.

The shift from passive to active enhances the popularity of ESG investing, as investors can align their values and also take advantage of the low cost and diversification of a traditional ETF. Nonetheless, investors must consider potential sector biases, given the fact that ETFs replicate the performance of sectors – the energy sector, for example, ranks structurally lower than the technology sector.

The Bubble

A bubble is formed when the market experiences a rapid escalation in the growth of a fund, with the indicator being the price to earnings ratio (P/E ratio). The ratio is primarily adopted to value a company by measuring the company’s current share price value relative to its per-share earnings. Investors can, therefore, use the P/E ratio to determine the relative price of ETFs. So, what do the P/E ratio figures indicate?

  1. A high P/E ratio indicates that the ETF price is high relative to earnings and could be overvalued
  2. A low P/E ratio may indicate that the current stock price is low relative to earnings

The ESG ETF market could only cause a bubble due to extremely high P/E ratios, take for example the extremely high P/E ratio during the Dot Com Bubble (1995-2000) (cf. 4). The iShares ESG Aware MSCI USA ETF currently adopts a P/E ratio of 24.78 which stands significantly lower than that of the Nasdaq Composite stock market index during the Dot Com Bubble, which reached a P/E ratio of 200. Fortunately, since ESG ETFs are active, Investment Managers can reconstitute the ETF holding if there is a market price overvaluation and consequently, mitigate the risk of a bubble.

Figure 4: Comparison of Price-to-Earnings Ratio Between Different Funds (Morning Star)

The Future

All in all, the continued growth and awareness surrounding ETFs has instigated a commitment from investors, triggering a shift from passive to active, making ESG investing more accessible. ESG ETFs are shifting investment philosophies away from passive index investing towards active and smart beta, identifying the positive impact of value-based investing within portfolios. While the P/E ratio of ESG ETFs are stable now, there is always the chance that it rises as the market continues to significantly expand. Ultimately, the next essential step needed to achieve the projected growth of almost $1.2 trillion by 2030 is for ESG ETFs to gain prominence in emerging markets which demonstrate high growth potential.

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