Does it pay to invest in ESG ETFs?

What is ESG investing?

ESG exchange traded funds (ETFs) bring together assets and securities with a shared concern for environmental, social, and governance (ESG) issues. Integrating ESG factors into their investment strategy, ESG ETFs are traded on security exchanges like stocks. Like all other ETFs, the risks and gains of owning a part of a pool of different assets are shared among all the ESG ETF shareholders.

"Some people refer to ESG investing, while others use terms like green investing, ethical investing, or sustainable investing," points out Solène Hanquier, Senior Director and Head of Responsible Investment at National Bank Investments. "Though the terminology isn't uniform or standardized, all those terms share a common goal of integrating environmental, social, and governance criteria into the stock selection, monitoring, and investing process."

Despite some perceptions that ESG investing is philanthropic, this is not the case. By integrating ESG criteria, investors seek to invest in companies that not only adopt sustainable practices, but also have good risk management and are well positioned to prosper in the long term.¹

As a result, there is no inherent disadvantage or trade-off with ESG investing. The key is a fund's ability to manage and oversee a pool of assets effectively and ensure meaningful returns for investors.

What are ESG criteria?

ESG investing enhances traditional asset analysis by integrating environment, social, and governance (ESG) factors. This approach helps identify risks and growth opportunities linked to these concerns.

Thus, fund managers take these factors into account when making investment decisions. Effective management is crucial for achieving growth and positive returns for investors.

The following table identifies some of the specific areas covered by ESG ETFs.

 

• Environmental factors - These include issues like climate change, air, and water pollution. Companies not accounting for their impact not only demonstrate a lack of corporate environmental responsibility, but they also increase their risk of being subject to fines and reputational damage. The consequences are not only bad for the environment, but also for stockholders - diminishing the value of the company and ultimately stock prices.
• Social factors - From human rights to data protection, social factors can have a significant impact on the ultimate value of an asset. Companies facing data breaches or criticism from human rights groups for poor labor conditions can suffer from decreased customer trust. Additionally, companies may experience higher employee turnover rates and face greater challenges in recruiting top talent, leading to increased costs and reduced efficiency. These kinds of social risks can ultimately impact a company's bottom line.
• Governance factors - Governance factors are linked to the way a company is run. This can include issues such as excessive executive compensation for CEOs or diversity concerns. Ultimately, effective governance is vital, since it impacts the short- and long-term prospects for company growth. Moreover, strong governance has a direct influence on both environmental and social factors. It helps ensure that a company not only operates responsibly but also promotes sustainable practices and equitable treatment across all its operations.

Self-directed investors should be aware that ESG ETFs have a variety of objectives. Some focus on specific industries and services, while others incorporate specific ESG concerns across a broad range of different sectors.

ESG strategies can also combine different approaches aimed at achieving various objectives.

These approaches can range from ESG integration to exclusions, shareholder engagement, or even selecting a theme related to ESG issues. As a result, it's important for self-directed investors to carefully evaluate the specific criteria and methodologies used by each fund to ensure they align with their personal values and financial goals.

For example, women in leadership ETFs and clean energy ETFs focus respectively on gender equity and the alternative energy sector (solar, wind, hydrogen, etc.). Some ETFs prioritize companies committed to reducing their carbon emission targets in line with the Paris Agreement guidelines, aiming to meet or exceed the 1.5-degree Celsius 2050 targets.

Why invest in ESG strategies?

ESG ETFs offer self-directed investors a way to invest in leading companies that contribute positively to global challenges, and that adopt approaches and implement projects that contribute to sustainable development. Research shows that companies integrating sustainable practices and ESG criteria into their strategies are often more resilient, better at managing risks, and more capable of attracting top talent, ultimately generating long-term value for shareholders.²

Sound environmental and social risk management can potentially influence equity returns, such as sectors like energy and materials. As a result, companies that manage ESG factors well are less likely to be impacted by disruptions from external or regulatory changes. They also often exhibit better risk management practices and could therefore be subject to lower downside risks.

Studies indicate that ESG strategies perform as well as traditional investment approaches.¹ Some portfolio managers recognize the potential for strong returns in sectors like clean energy and smart agriculture, which offer solutions to global challenges. These industries are considered to have strong growth potential and better ESG risk management.

An ESG focus can also mitigate long-term financial risk since the companies assembled in an ESG ETF will typically be more focused on:

• Respecting or anticipating stricter regulations and environmental controls.
• Making supply chain improvements that can have positive impacts on the environment, human rights, as well as long term cost benefits.
• Improved governance and controls that lower the risk of corporate corruption or lax security and oversight.

Some ESG ETFs include companies that are offering solutions to global challenges, such as climate change, the housing crisis, and health care - activities that benefit the communities we live in and the broader environment we all depend on.

The ESG ETF process

Like other exchange traded funds, ESG ETFs are managed by fund managers who are responsible for the selection and monitoring of assets within the ETF’s pool of securities. ETFs offer cost-effectiveness compared to buying individual stocks, coupled with expert management.

The ESG score of an ETF or an individual stock is typically assessed by independent ESG raters such as Sustainanalytics, MSCI, ISS, and S&P Trucost. These third-party services provide objective rankings of the ESG performance of individual companies and the ETFs they may be associated with.

Some fund managers may apply exclusions when choosing the securities to pool in an ETF. They will avoid certain sectors like tobacco or oil and gas or put fixed percentage limits on the level of revenue generated in these sectors by the companies included in the ETFs they manage.

Types of ESG ETFs

ESG considerations are increasingly integral to investment decisions, extending beyond companies explicitly focused on ESG. Governments, businesses, and individuals globally recognize the risks of ESG mismanagement and its impact on the environment, communities, and financial outcomes.

Organizations like the CIFSC (external link), a Canadian Investment Funds Standards Committee, have a list of ESG-focused funds, detailing the responsible investment approach (ESG integration, best-in-class, thematic, etc.) adopted by each fund. Self-directed investors shouldn't limit themselves to 'ESG' in the name of the ETF or security because other related terms may be used, including sustainable development, or may refer to a specific theme, such as climate change or diversity.

ESG investing can allow you to follow your convictions and invest in forward-looking companies. It also encourages companies and governments to advance their climate and environment agreements, benefiting both the planet and long-term financial goals.

In the coming years, ESG strategies could become increasingly important. As generational wealth shifts, more women and millennials - two groups who are more aware and attuned to ESG concerns - will likely encourage more ESG investing in the market.³

ESG ETFs can be a way to contribute to a more sustainable economy. Nevertheless, it's important to review the specific ESG approach of an ETF and its rankings with third-party data providers before making investment decisions.

Do your research, invest wisely, and take the next step in your investment journey!

Ready to start investing in ESG ETFs?

To consult research on this topic, visit the NBDB online brokerage platform.

• Under the Markets tab, select the ETF Center
• Select the ETF Research tab
• Under NBF ETF Research, select ETF Research & Strategy