A growing investment option has been sustainable ETFs (Exchange Traded Funds). This allows investors to blend a environmentally-friendly investment target into their existing strategies. These are a popular product due to the diversification they can offer, low expense ratios and a lot of flexibility dependent on the individual investor. The green or sustainable aspect adds an ESG element, to further diversify the portfolio. While offering plenty of benefits, we see some risks in investing in green ETFs which we must be wary of.
What is an ETF?
To understand what a Green ETF is, we first must understand what an ETF is.
An ETF is a pooled asset. What this means is it is a basket of securities, that tracks a variety of different assets. This is where the flexibility comes in. ETFs can contain investments in stocks, bonds, commodities, currencies or indices. As it can hold multiple assets, it is a diversified asset, as opposed to purchasing a single stock. The flexibility plays into the ETF's favour once again, since it can offer diversification through sectors. We can purchase an ETF focused in on a specific sector or industry, or we can purchase an ETF which covers hundreds of stock over multiple sectors.
The name itself is derived from the fact they are marketable securities (traded on an exchange) and so like a stock have a price which varies day-to-day.
To demonstrate the cost-advantage of an ETF, let us take an example. Let's say we have an ETF which contains 100 stocks from the TMT industry. We have two alternative investment strategies available to us as an investor interested in entering a position in the TMT industry. We can execute 100 separate orders and purchase each of the 100 stocks individually. Not only is this time-consuming and laborious, the price of the stocks we want to buy may change between the time it takes to buy the 1st stock and 100th stock. This is an issue we want to avoid, and hence an ETF is the alternative solution. We can purchase this 'basket' which contains the 100 stocks we want to purchase, by executing just one transaction - much more efficient.
This avoids the issue of broker commissions, as 100 transactions will mean 100 commission charges, whereas we only face 1 with an ETF transaction.
Another cost to consider is the expense ratio - the cost to operate and manage the fund. Typically, for passively-managed ETFs, this is low, and allows the investors minimal involvement if they so wish. Actively-managed ETFs come with higher costs.
Sustainable ETFs
Now after that quick run-down of ETFs, let's move on to sustainable ETFs. The mechanism is exactly the same; what's different is the actual make-up of the fund.
Typically, these funds are investing in stocks of companies who are involved in green investment projects, or support the use of sustainable technologies. The definition of 'green' is one of the most heavily debated topics, and the answer is: there is no answer!
Whether these include companies which have already made advancements in green technology and operations, or whether it's those companies looking to do so in the future is also a question the investor must ask when choosing which green ETFs to pick.
While our own definitions of sustainability differ, the specific sustainable ETFs have their own criteria for eligibility.
Are Sustainable ETFs a good investment?
Of course, for an environmentally-concerned investor, a green ETF seems like a much better choice than a standard ETF.
Where differences lie is with costs as well however. Typically, we see green ETFs as having higher expense ratios. This is due to the additional costs of fund manager's time to research and analyse whether the specific companies in the green ETFs truly adhere to the 'green' criteria for that ETF.
While ETFs have become very popular, green ETFs are still on the upward trend, but not quite there. There is less liquidity and less diversification for now. It is likely that with increasing climate concerns and spotlight focus of a clean-energy transition, these will continue to be popular assets for the future.
However, there are still concerns to do with eligibility and green-washing. Many 'green' statistics are difficult to compute to a high degree of accuracy. Companies are becoming aware more investors are looking into ESG statistics, and so there may be issues to do with exaggerated figures in the form of green-washing.
Around August 2022, the SEC proposed a 'Names Rule' and strict requirements on ESG disclosures. These were aimed and praised to eradicate greenwashing, however have received backlash for being costly for fund providers. It seems there is a lot of disagreement over how to resolve the identification problem with green ETFs, and so their progress has been hindered.
In fact, an interesting revelation has been the so-called 'anti-ESG ETFs'. An example is Constrained Capital's ESG Orphans ETF (ORFN). This launched in May 2022, and founder Mark Neuman has said:
The growing popularity of ESG meant many portfolios were underweight companies involved in arms or tobacco, which offered greater potential upside
Conclusions: ESG and Hedging Strategies
Without universal definitions, sustainable ETFs will always face criticism over the precise aims of the companies being invested in. Having said this, they offer a unique type of diversification and ease of transaction which many other products fail to provide right now. For an ESG-conscious investor, green ETFs seem a sensible method to place bets on the future profitability of ESG.
For investors who are not as ESG-minded, ETFs are one of the best tools for hedging strategies. Purchasing an ETF short can be a useful tool if an investor has built a position in several individual stocks, to protect against stock market falls. In a volatile environment, hedging positions seems more and more essential. For example, ETFs such as SPXU are shorts on the SP500, and so move inversely to the SP500 index. If an investor has purchased several stocks in the SP500 it would be wise to purchase the SPXU ETF to hedge this position, such that in the case of a crash in the SP500, while the individual long positions in the stocks will lose money, the ETF will provide a positive return as it is a short position on the SP500.
If an investor is concerned about inflation in the future. An ETF can be used to hedge against this risk as well. Generally commodities tend to rise in value with inflation, whereas stocks do not observe this pattern. Therefore, purchasing a commodity ETF when one anitcipated inflation in the future may be a safe bet to hedge inflation. The GLD ETF can be purchased in this case.
ETFs are one of the most versatile products and assets, which can be used to hedge or place bets on a particular view. The ease of transaction and volumes also contribute to the benefits of using ETFs.