Morgan Stanley
  • Thoughts on the Market
  • Sep 16, 2020

The ABCs of ESG ETFs

With Michael Zezas
U.S. Public Policy Research for Investors

On this special edition of the podcast, Jessica Alsford, Head of the Global Sustainability Research Team talks with Michael Zezas about the important role ETFs are playing for ESG investing.

In this Thoughts on the Market series, Michael Zezas offers perspective on how U.S. public policy affects equity and fixed income markets, including trade tensions, infrastructure and government policy. Listen to this week’s update.

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Current Episode Transcript

Zezas: Welcome to Thoughts on the Market. I'm Michael Zezas, Head of Public Policy Research and Municipal Strategy for Morgan Stanley.

Alsford: And I'm Jessica Alsford, Head of the Global Sustainability Research Team.

Zezas: And on this special edition of the podcast, we'll be talking about ESG investing and the increasingly important role ETFs are playing in this space. It's Wednesday, September 16th, at 10:00 a.m. in New York.

Zezas: Jess, this year we've seen a new surge of interest in the ESG theme. I want to get into the rise of ESG ETFs in particular, but maybe first you can talk about the increase in interest in the sustainable and ESG space over the last couple of years.

Alsford: It's been really interesting because I've been in this space for about eight years now, and in 2019 - end of 2018, beginning of 2019 - we really started to see this rapid increase in the amount of interest we were getting from investors in ESG. And whereas in the past it had been really focused more in Europe and more your long term, long-only investors, suddenly we were getting this change from a geographic perspective, so far more interest coming out of the U.S. and also in terms of the type of investor. So, it's hard to really pinpoint one reason why this happened. I actually think it's a combination of a number of different things. I think, first of all, you had some real societal shifts, so climate change in particular went from being a very peripheral issue to one that was definitely much more mainstream with regards to media and also then from an investment perspective. We saw a change in asset owner demands, asking investment managers to think about ESG and sustainability more proactively. And there are also some regulatory changes, which again, increased that focus on some of those key ESG issues.

Alsford: And so this really all combined to make ESG no longer the domain of a more niche area of investing, but starting to really see some of these themes and trends impacting asset flows and asset prices across the broader market.

Zezas: Yeah and ESG ETF assets under management in particular have quadrupled since January of 2019. What's behind the rapid appreciation in this particular way to invest in the ESG theme?

Alsford: Sustained investing in ESG is clearly a way for the active asset management industry to differentiate itself. And with a lot of these themes they're not black and white, and so it does take proprietary analysis, it requires engagement with issuers to really understand what's going on. But, I think it's particularly interesting that over the last 18 months or so, you have started to see ESG being adopted from the passive perspective.

Alsford: And this really is in line with our view that ESG means lots of things to different people. And what the passive side, which the ESG ETFs can do is provide an alternative way of defining ESG, which a lot of the time can be from the ETF perspective, investing in all sectors, but investing in those issuers that are deemed to be more sustainable than their peers. There are also some thematic ETFs themes like climate change. Environmental themes are particularly popular and it's a more systematic way of creating some of these ESG products.

Zezas: So is it fair to say when it comes to ESG ETFs that Europe is a bit further ahead of the U.S.? And if so, why? 

Alsford: So the flows to ESG ETFs have been more skewed towards Europe than the U.S. so far. In some respects, this really just reflects the overall trend that we've seen in sustainable investing. So, sustainable investing really started in Europe and then was adopted later on by U.S. asset owners, asset managers, and they're catching up very quickly. And so we think on the ETF side that a similar trend will happen.

Alsford: And there is a difference in terms of the geographic split by flows, verses by the actual issuers that have been invested in. So if we look at the top 25 holdings of the ESG ETFs, 19 of that 25 are actually U.S. issuers. And so you can see how actually investing in the ESG theme is becoming very global in that sense.

Zezas: And is it fair to say that if you are buying an ESG ETF, that you're also buying a fair amount of exposure to tech and health care? And why do you think that is?

Alsford: Yeah, it's interesting, actually, because you might expect some other sectors to be dominant there where there is perhaps more of a clear environmental angle, for example. What we found, though, with a lot of the ESG ETFs, is that they are investing across all sectors. And so, often it might be a best in class approach where companies within a particular sector are being rated on that ESG, and then the ETFs are investing in the highest scoring issuers within each sector. So for the moment, we do see that actually the ESG ETFs are pretty similar to the market in terms of their sector focus.

Alsford: If we look at the broader ESG market, where we have seen some of the biggest impacts in terms of asset flows and asset prices is around this environmental theme. And so if you take sectors like oil and gas versus utilities, for example, a clear differentiation in performance, partly due to their high versus low carbon characteristics. And so we'll be looking to see whether some of those types of investment trends that we've seen on the active side are starting to be reflected more on the passive side as well.

Zezas: And do you think there's any interaction between the COVID 19 pandemic and the adoption of ESG investing and in particular ESG ETFs?

Alsford: Now what we've seen that has changed from an ESG perspective during, and as we're coming out of the COVID crisis, is this increased focus on the S. And so, as I said earlier, the environmental part of ESG has been a key topic, a key investment trend for a couple of years now, but it's always been quite difficult to really know exactly how to invest from the social perspective. But what we are seeing now is far more focus on how corporates have been treating their various stakeholders throughout the pandemic, and definitely far more scrutiny on issues like diversity and inclusion as well.

Alsford: So I think coming out of COVID, a couple of thoughts: one, overall sustainable investing has proved to be very resilient. And then secondly, I think it's really demonstrated the need to look at the whole spectrum of ESG and sustainability as opposed to just focusing in on the E. And if we look at this increase in focus on the S side as well as the E post COVID, I think looking ahead, what's going to be particularly important is how some of the societal shifts continue, and also whether you see a policy response in some of these areas.

Alsford: So, from your perspective, Michael, how do you see these potential drivers and do you think it will lead to further adoption of these ESG themes and trends going forward?

Zezas: Yeah, I think about this question a lot. In particular as someone who tries to guide fixed income investors as a municipal strategist for the firm. And one of the things that can really accelerate adoption is policymakers, frankly, making more available the types of projects that require investment that could fit ESG mandates. And when we think about the U.S. election in particular, the way this comes up is what type of outcome will finally drive infrastructure investment, in particular green infrastructure investment.

Zezas: And the short version of the answer to that question is that you probably need one party or the other to not just win the White House, but also win both chambers of Congress in order to create the legislative conditions and availability for enacting a meaningful piece of infrastructure investing.

Zezas: But it's a process. It's still at its sort of nascent stages. But over time, we think there's a snowball effect that makes this a much more prevalent theme in U.S. fixed income markets.

Zezas: Jess, thanks so much for taking the time to talk with me today.

Alsford: It's great speaking to you, Michael.

Zezas: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show. Thanks for listening. 

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