Sustainable investments with ETFs

• Level: For Advanced
• Reading duration: 5 minutes

Investors in Europe now have an incredible choice of environmental, social, and governance (ESG) investments, not to mention socially responsible investments (SRI). Both the ESG and SRI labels tell you that your ETF tracks a sustainability index that:

• Excludes or down weights so-called ‘sin stocks’. Sin stocks are shares in firms that have a negative environmental or social footprint – classic examples are corporations that profit from coal power or weaponry
• The index upweights or only includes companies with a high sustainability rating (e.g. renewable energy firms) or those that exhibit positive social values (e.g. firms that have built an ethical supply chain)

Implementing your values

While the market is moving in the right direction, expressing your individual values through the wide choice of ESG/SRI ETFs available can be a confusing task. A good starting place is to decide whether you want to buy into a product that avoids companies that you deem to be unethical or harmful. Industries that are commonly excluded from ESG/SRI indices include:

• Armaments
• Tobacco
• Alcohol
• Gambling
• Adult entertainment
• Nuclear energy
• Coal mining
• Human genetics

Some indices simply screen out companies that produce, supply or distribute products associated with these areas. Or companies may be excluded if they earn over a certain revenue threshold from these industries. Barring such companies is known as negative screening. Positive screening, by contrast, enables you to invest in companies with strong environmental, social, and/or governance (ESG) credentials. How do you know which companies have a negative impact and which are positive? The impact of a company's policies can be rated by the index provider, and/or independent bodies, or they may be excluded because they’re classified as part of a particular industry. Each ESG/SRI index uses a different blend of positive and negative screening - although some may only use negative screening. The criteria should be made readily available by the index provider, and it should explain how companies are excluded and/or weighted for ESG factors. Choose your index carefully so that it best expresses your values. Some indices exclude oil and coal equities but some do not. Some indices enable you to block companies that violate international standards such as the UN Global Compact. The UN Global compact is a code of ethics that demands companies uphold the human rights declaration, enforce the ban on child labour, and respect anti-corruption guidelines, among other important principles. A useful tip is to check out the table in our investment guide to the best socially responsible investing (SRI) ETFs. From there, you can very quickly narrow your choices down to the ESG/SRI indices which best reflect the sin stocks you wish to boycott. The guide also summarises each index’s methodology and links to the sustainable ETFs which track your chosen benchmark.

Investing in sustainable companies using ETFs

Another option is to choose ETFs that purely invest in companies focussed on green technology, or otherwise operate in areas essential to a sustainable world. Investors who want to try to earn an above-market return by gaining exposure to these industries can use ETFs tracking thematic indices. Themes include investing in clean water, renewable energy, electric transport and future driving technology. However, be aware that themed indices usually select companies by the proportion of their business associated with a theme and not by ESG rating. See our guide on megatrends for more.

The impact of large institutions on sustainable investing

Large institutional investors manage billions of euros / pounds on behalf of pensions, insurance firms, and regular citizens. Their responsibility to invest that capital sustainably inevitably includes a moral dimension that actually gave rise to socially responsible investing in the first place. The scale of institutional capital means that many ESG/SRI indices and ETFs are designed primarily with large investors in mind. Institutional investors use sustainability audits to try to avoid extreme risks such as fraud scandals (Wirecard and Volkswagen are good examples) or industrial disasters (such as the Vale dam breach in Brazil or the BP oil spill). Similarly, they often exclude some controversial companies such as those that manufacture cluster bombs. Government regulation also moves the market which is why indices exist to facilitate compliance with the Paris Climate Agreement. From a retail investor’s perspective, you can be reassured that institutional investors will do their due diligence when selecting ETFs. So if an ETF is attracting significant capital flows from the institutional sector, you can regard that as a positive proof point so long as the product aligns with your values and you remember that investing success is not guaranteed.

Putting it all together

Now we’ve reviewed the ESG/SRI investing landscape, let’s sum up the key takeaways in one last graphic:

Sustainable strategies for your investment goal