SA brought the world the first heart transplant, cement-less concrete and the vuvuzela. Yet we sometimes lag behind when it comes to embracing global trends. Think colour TV, Dynasty-style shoulder pads, Diet Coke or the first Starbucks coffee shop. So it’s only a matter of time until an investment instrument that is taking Europe and the US by storm gains local traction.

The spotlight has turned to ESG ETFs – exchange-traded funds that reduce investors’ exposure to controversial business activities and prioritise investing in companies with high environmental, social and governance (ESG) standards.

This type of fund reached a tipping point in 2020, according to TrackInsight, a global ETF-analysis platform that markets itself as the first of its kind worldwide. ‘ESG ETFs witnessed an incredible 223% growth over the year, achieving a new record of $189 billion in assets under management,’ says the France-headquartered platform. ‘ESG ETFs captured $97 billion of flows over the course of 2020 and nearly 200 ESG ETFs were brought to market during the same period, as ESG is set to become a key battleground for issuers over 2021.’

While these ‘battlegrounds’ are primarily located at European and US stock exchanges, SA saw its first two ESG ETF listings on the JSE in September 2020. Issued by Satrix (tracking MSCI indices), one focuses on developed markets and the other on emerging global markets. The most recent listing of an ESG ETF took place in April this year – the Sygnia Itrix S&P Global 1200 ESG ETF, which has a strategic allocation to global equities.

These are exciting developments, according to Nerina Visser, director at etfSA Investment Services, who 10 years ago headed Nedbank’s listing of the first green ETF on the JSE. ‘Back then it didn’t work out, because the market just wasn’t ready for it,’ she says. ‘But I absolutely believe there’s a need for such products in South Africa and we will see more of this coming in due course.’

While ETFs as products have already been available at the JSE for two decades; it’s the innovative ESG-themed version that is new.

Adèle Hattingh, JSE Business Development and Exchange Traded Products Manager, sums up why ETFs are ideal investment tools for retail and institutional investors. ‘They offer a basket of various assets within a single product, presenting a transparent, cost-effective and diversified solution and offering exposure to all kinds of assets – locally as well as globally,’ she says. ‘They are also unique in that through this listed instrument, investors are offered a chance to invest in particular themes, such as ESG, beyond the traditional asset-class exposure.’

This way, investors are able to align their investment decision with their investment philosophy and values. According to Shameela Soobramoney, JSE Chief Sustainability Officer, ‘in the South African context – where there is inequality, where climate change is a significant risk and where many investors have been affected by corporate governance scandals – investors are searching for companies that recognise their responsibility to bring about change, not just for their own organisations but their impact on the broader societal and environmental context in which they operate’.

Meanwhile, Visser adds that ‘if I had one wish in this space, I’d wish for a South African ETF with a strong social impact. European ESG ETFs tend to have an environmental focus, whereas I think in our country with its burning social issues, the “S” in ESG is more pressing. The “G” should be non-negotiable wherever you are, as it refers to the fundamentals of good governance and corporate ethics’.

To be clear, the environmental metrics of ESG typically cover themes such as climate  risks, natural-resources scarcity, pollution and waste, and environmental opportunities (according to Satrix). Social metrics include labour issues and product liability, human rights, risks such as data security, and stakeholder opposition. Governance encompasses items relating to corporate governance and behaviour such as board quality, diversity and effectiveness.

Climate change, as one of the main focus areas of ESG, is increasingly recognised as a mainstream investment issue with serious potential implications for financial risk and returns, according to research by Norton Rose Fulbright South Africa. As a result of varying climate policies and physical manifestations of climate change, investments will be exposed to different levels of risk, depending on the sector and geographical location of their underlying operations. This makes ESG awareness substantially important from an investor perspective, says the firm.

‘Regulatory risks, physical risks and business risks are three ways in which climate change can have an impact on investments, each of which carries its own economic implications and exposures. Investing in “dirty” business activities exposes investors and shareholders to projects that may become stranded assets in the future. In other words, it exposes investors to the risk of investing in assets that are incapable of meeting their economic life as a result of regulatory, economic or physical changes associated with climate change and the just transition to a low-carbon economy. Financial institutions and investors play a critical role in this transition,’ it says.

‘ESG is capturing hearts and minds,’ says Barry Panulo, senior project manager for innovative finance at the Bertha Centre for Social Innovation and Entrepreneurship, which is part of UCT’s Graduate School of Business. ‘Investors are better informed on its relevance to long-term investment performance, and unsustainable options are increasingly irreconcilable with the personal values of asset owners. Enterprising firms appreciate this and are rising to the challenge by innovating sustainable investment products such as ESG ETFs.’

The take-up of the Satrix MSCI World ESG Enhanced ETF and Satrix MSCI Emerging Markets ESG Enhanced ETF – has been steady, says Kingsley Williams, chief investment officer of Satrix. ‘Investors recognise they can make a positive impact on the planet while enjoying similar returns offered by MSCI World and MSCI Emerging Markets. The adoption of these strategies is likely to occur as investors allocate new capital or switch into these ETFs as they rebalance their portfolios. Furthermore, this can be achieved without needing to pay a higher fee relative to the non-ESG ETFs tracking [parent funds].’ The indices screen out companies that are involved in controversial activities such as nuclear weapons, civilian firearms and thermal coal, or are implicated in severe ESG-related misbehaviour.

Asked how the Satrix ESG ETFs are tilted in their ESG weighting, Williams says that ‘the index design and construction doesn’t specifically allocate more prominence to E, S or G from a top-down perspective, but this will be a function of the weighting of the companies operating within each sector. Given that the IT industry dominates MSCI World, social considerations are likely to dominate the overall ESG score of the MSCI World ESG Enhanced Focus Index’.

Investors should note, however, that the menu of sustainable investing covers different degrees of social, environmental and governance flavour. In terms of spiciness, imagine ESG ETFs as mild lemon and impact investing as flaming hot peri-peri. Typically, ESG ETFs prioritise financial return (while measuring how companies are progressing in their efforts to improve ESG focus), while impact investors strive for the greatest societal or environmental outcomes (to the extent that they can lose their investment return if the predetermined goals haven’t been achieved).

Panulo, who was involved in launching the Impact Bond Innovation Fund (which, in October 2018, became the Global South’s first social-impact bond focused on early childhood development), explains that ‘impact investors allocate capital with the intention of generating both a financial return and a measurable, positive effect on people or the planet. Most ESG ETFs lack the impact intentionality and measurement that distinguishes impact investment from ESG. Instead, their focus is on avoiding harm or harnessing ESG factors to improve risk-adjusted financial returns’.

At present, ESG scores can still vary significantly between data providers as the rating methodologies are not yet well standardised, says Panulo. ‘This erodes the degree of conviction managers can achieve when using these inputs to build ESG portfolios. Screening-based ETF strategies can also be challenging to implement in highly concentrated financial markets like South Africa’s since reducing holdings of large-capitalisation securities may impair liquidity and performance relative to conventional benchmarks.’

Yet ESG ETFs are constantly evolving. ‘Today we’re seeing more ESG metrics being implemented on an enhanced basis rather than the original exclusion basis,’ says Visser, who rejects the widespread criticism of ETF shareholders being docile and not interested in shareholder activism. ‘I think the opposite is true: it’s the active investors who have the choice to disinvest from a company if they’re not happy with how it’s being run. They can disengage from it and walk away, potentially creating stranded assets. But as a passive, index-tracking investor I don’t have that choice,’ she says.

‘Divesting from a climate-unfriendly business isn’t an option as long as it remains in the index that I’m tracking. Therefore it’s in my interest to engage company management to help make the changes I want to see.’

All ETF providers have the responsibility to exercise voting authority over the underlying companies that they hold within their funds, says Hattingh. ‘As ETF providers are seen as long-term shareholders, they have a particular awareness in impacting companies’ management decisions over the long run.’

It seems only a question of time until the global ESG ETFs trend sweeps into SA to provide investment returns and nudge companies into behaving more responsibly.

By Silke Colquhoun
Images: Gallo/Getty Images