The demand for sustainable investing is growing steadily and showing no sign of ebbing out. In a recent survey, 75% of respondents in the entire globe indicated they are on course to integrate ESG into their investment focus. There are a number of ways that people can use sustainable investing, but one of the most preferred options is ESG exchange-traded funds (ETFs).
It is a relatively new product and people not conversant with securities and other investment instruments in the capital markets might find it confusing. So, how does an ESG ETF work? What are the main categories of exchange-traded funds (ETFs)? Here is everything you need to know to make the right investing decision and diversify your portfolio.
What is an ESG ETF?
ESG investing can help investors cast their eyes far beyond the conventional financial reporting to understand the targeted companies, long term returns and risk exposure. An ESG ETF is a category of fund that allows investors to target companies with environmental, social, and governance (ESG) sustainability commitment. They combine two main strategies:
- ETF Investing: ETFs invest in a collection of bonds, stocks and other high-potential assets. They help to track specific indexes and offer investors a flexible and affordable way of building diversified investment portfolios.
- Responsible investment: This is an umbrella term that describes ways to add ESG metrics and factors into the investment process. Therefore, it is an important metric that allows investors to focus on the things they value more more on the market or believe will bring more returns.
The S&P 500 ESG ETF
S&P Dow Jones Indices created an S&P 500 index to act as the main benchmark for the Xtrackers S&P 500 ESG ETF. The index’s target is to get 75% of the float market cap of every Global Industry Classification Standard Industry Group using the S&P 500 Index. This score screens out companies that have a low United Nations Global Impact Score (UNGC) score, involved with controversial weapons, and those dealing with tobacco.
S&P 500 ESG Exchange Traded Fund (ETF) helps to enhance sustainability representation compared to the standard US benchmark. For example, it gives over 8% exposure to firms that assess their sources of Scope 3 emissions, over 9% exposure to firms with GHG reduction goals, and over 10% 3rd party verified emission data. These ESG indexing models can help to give enhanced risk-adjusted returns for investors with long-term goals.
Apart from Xtrackers S&P 500 ESG ETF, you might also want to check iShares by BlackRock. Check closely yo compare their year-on-year performance, price, and different ESG metrics of interest.
Benefits of ESG ETFs
ETFs make it Easy to Adopt Responsible Investment
Smart investors know that targeting a single investment instrument or company can be too risky. Therefore, ESG ETFs help to simplify the number of sustainable investment options for their portfolios. For example, the selected ETF might focus on firms with high ratings. They can even pick the ETF that screens out unwanted parameters, such as child labour and tobacco.
The ESG ETF they select can also provide a one-ticket approach where several ETFs are combined into a single diversified portfolio (portfolio solution). The portfolio solution further allows investors to identify the preferred risk levels and asset allocation in line with preset goals. It is a good idea to work with a professional manager to monitor and rebalance such expanded portfolios for more involvement.
All managed funds, irrespective of their structure, come with some operating costs, from custody-related charges to portfolio management fees. The cost history can help you in determining the expected returns.
ESG ETF operation costs can be reduced compared to open-end mutual funds on the market. The reduced costs can also be achieved through client-service types of costs getting passed to the firm holding the ETF accounts. ETFs also come with reduced costs when it comes to monthly statements, transfers and notifications.
Unlike the traditional types of open-ended funds that are required to send regular (monthly) statements, ETFs do not.
Statements and reports from ESG ETF sponsors are only required to be directed to the authorized participants. The reduced administrative burden associated with record keeping and service implies that ETFs can enjoy lower overhead costs and part of the savings passed to the investors.
ETFs come with two major benefits compared to standard mutual funds. Because of the structural difference, investors are charged higher capital gains tax compared to ESG ETFs. Capital gains tax is only incurred when an investor sells an ETF, but mutual funds attract capital gains taxes in the entire life of the investment.
However, the tax situation when it comes to dividends is less advantageous for investors holding ETFs. ESG ETFs attract two types of dividends: qualified and unqualified. Qualified ETF dividends are issued when the investor holds the instruments or at least 60 days before the date of dividend payout. Tax rate for qualified dividends can range from 5% to 15%, depending on the set income tax rate.
However, unqualified dividends attract tax based on the investor’s income tax rate. Remember that you can avoid the taxes by targeting companies based in jurisdictions, such as Hong Kong, that do not have withholding taxes on capital gains.
Excellent for Diversification
Investors aiming to get rapid exposure to specific industries, countries, styles and sectors but lack expertise can always count on ETFs in the respective areas. ESG ETFs are now traded in almost every asset class, including shares and commodities. Furthermore, their structures can help you target a specific trading industry.
Even in situations where investors might be willing to take a specific risk, but taxes or rules stand in the way, an ESG ETF that shorts an industry can help them achieve the targeted goals.
Higher ESG Rating is Usually Linked to Companies with Better Performance
Many companies that have good ESG performance tend to be more profitable. For example, the MSCI Canada ESG Leaders Index, which operates as a cap-weighted index offering investors exposure to firms with high sustainability ratings, reported a return of 11.25%. This was way higher than the 6.21% reported for the standard MSCI Canada Index. Since its inception in 2007, the MSCI index has returned 2% points better compared to the general Canadian counterparts.
ESG investing is growing rapidly and, as we have demonstrated in this post, it comes with a host of benefits. It is now transforming from being a niche to a core investment in many personal and professional investment portfolios. To help you understand ESG ETFs well, how returns are calculated, and make the right decision, consider working with our experts at Diginex.com.
Talk to our experts in ESG ETFs now for all the assistance that you want on ESG and profitable investing.