ESG Investing – Are ETFs Part Of The Solution Or The Problem?

Engagement is seen as one of the keys for successfully implementing and executing an ESG (Environmental, Social, and Corporate Governance) strategy within a portfolio. This is because engagement enables the portfolio manager to get in contact with the senior management of a company and to give them and their investors a voice via voting at shareholder meetings. With regard to this, ETFs are often criticised as failing at these important tasks since they are passive instruments which follow an index and allocate their capital among all constituents of a benchmark index, regardless of their ESG profiles. All the while, they can’t divest from a company as long as it is a constituent of a benchmark index. In addition, it is often said that the manager of passive products does not execute voting rights since they have, by definition, no opinion on the companies themselves.

If all these arguments were right, I would agree with the critiques and state that ETFs are rather part of the problem than the solution.

That said, things are not as simple as they may look like upon first view. This is especially true when it comes to the critiques above, as these seem to be logical, but they don’t take the dynamics of the ETF ecosystem into account. Apparently, it is correct that ETFs buy the constituents of their underlying indices. Therefore, the ETF promoter needs to ensure that the respective index is constructed based on the criteria he wants to represent in the ETF. If an ETF claims to invest, for example, in a given market without any exposure to fossil fuel and energy, the promoter needs to ensure that this demand is met by the index he chooses for the ETF. If the choices available do not meet the demand of an ETF promoter, they can also have indices created based on their own very specific criteria. These indices can be in-house solutions or indices based on the methodology of a given index promoter. As a result, the respective ETFs can invest in companies that fulfil the ESG criteria set by the ETF promoter and if they don’t meet the criteria any more, the ETF promoter is able to remove them from the respective indices.

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