Responsible Investing

An ESG ETF Strategy to Meet Growing Demand

January 2020

Mark Raes

MD, Head of Products, BMO Global Asset Management

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As the ESG landscape evolves to become a mainstay of investment management, Mark Raes, Head of Product, BMO Global Asset Management, discusses how institutions globally can gain from new ESG ETFs to uphold values – and maximize risk-adjusted returns – with all the benefits investors have come to rely on from BMO ETFs.

ESG Evolution: Opportunity, Not Opportunity Cost

As responsible investment (RI) continues its rise to the forefront of decision-making for asset managers, owners and institutions worldwide, the clear message is that the entire infrastructure of investment management has changed with Environmental, Social, and Governance (ESG) considerations no longer at the sidelines. Instead of the dated negative associations with performance penalty, we have simply moved forward to understand ESG measurement as essential to sound financial analysis and sustainable operations. While exclusionary screening remains a valid approach within RI, there has been a shift over the last decade toward more inclusionary strategies such as ESG integration, and active ownership through engagement and shareholder voting to help enhance long-term value. And returns are now living up to the hype (see graph below). Institutions globally are focused – more than ever before – on using ESG analysis to identify risks and opportunities that may not be revealed through traditional financial metrics. Currently, the process is about more than aligning values with investments – it’s about valuation, and how these fundamental considerations enrich the quality of our analysis and ensure we earn robust returns over time. According to a recent survey, more than 70% of institutional investors use ESG principles as part of their processes.1

Performance of RI Funds in Canada

Performance of Responsible Investment funds

Source: BMO Global Asset Management, June 30, 2019.

ESG and ETFs Rise Together

BMO Global Asset Management has been leading the charge2 in this maturing ESG landscape, drawing on 35 years of RI experience,3 and a comprehensive suite of specialized strategies focused on sustainable, long-term performance. Our latest foray in the field is the launch of new ESG ETFs. This ESG suite is designed to meet the needs of institutional investors globally, driven not only by increasing RI demand, but also by the sheer growth in ETF usage by asset managers as a core allocation.

The rise of ESG investing and ETFs have gone hand in hand: in fact, Canadian institutions have made aggressive use of ETFs in the last two years as they navigate unpredictable geopolitical events, with a recent study from Greenwich Associates showing that the share of those using ETFs to displace other investment vehicles climbed to 45% in 2018 from 30% in 2017.4 Aside from their flexibility, ease of use, cost-effectiveness and transparency, the research highlights that ESG enthusiasm is also expected to emerge as an important source of demand for ETFs in Canada over a longer time horizon.5 ETF simplicity is no doubt a factor here, with the ability to quickly hone in on an asset class or geography. From 2015 to June 2019, AUM of ESG ETFs quadrupled, growing from US$6 billion to US$25 billion, mainly explained by large positive net inflows, particularly in Europe.6

In response, we’ve teamed up with MSCI Inc. (MSCI), the world’s largest provider of established ESG indexes and research, to bring out ESG ETFs that helps institutions mitigate risk and bolster returns, through a rigorous ranking process and exhaustive coverage of more than 7,500 companies. The partnership with MSCI builds on our reputation for ETF innovation – and ESG legacy.

BMO MSCI Global ESG Leaders Index ETF, for example, uses MSCI ESG ratings, which are based on a comprehensive approach involving the evaluation of relevant ESG factors by industry; scoring models that focus on risk exposure, not just disclosure; and a final score that identifies leaders and laggards from AAA to CCC. Though some exclusionary screens are used to avoid controversial companies, the focus is on the selection of companies with the best ESG footprint in each sector. The index provider’s rankings also include monitoring of ESG risks, and regular updates of public documents and third-party data sets – such as from governments and NGOs – to minimize reliance on voluntary disclosure. Importantly for institutions, companies are compared on a like-for-like sector basis (i.e. oil and gas firms are not compared to banks), which allows us to have full market exposure, and maintain a lower tracking error because the ETF is deliberately built around the market.

MSCI uses 156 industry model variants to focus on the key issues that pose the most significant risks to a company relative to its own peers, with each “Key Issue” typically comprising between 5%-30% of the overall ESG rating. In other words, an oil company could have a high ESG ranking based on its sustainability leadership in its industry. The benefit is that BMO MSCI Global ESG Leaders Index ETF does not vastly deviate from the broad benchmark through outright sector exclusion, while also providing some highly sought-after ESG differentiation at the same time. Indeed, positive performance impact, including mitigating risk and enhancing returns, is now the top-cited reason for incorporating an ESG-based approach for institutional investors in Canada, the U.S. and the UK.1

Strategy Implementation for BMO MSCI ESG Leaders ETFs

Sector Representation

  • 50% target sector representation per GICs sector and sub-region (to avoid regional and sector biases) relative to parent index

Minimum ESG Rating

  • Minimum ESG rating BB

Minimum Controversy Score

  • Screens ongoing severe controversies

Weighting Scheme

  • Market cap weighted
  • Rebalanced quarterly with ongoing event-related maintenance

Exclusions

  • ≥ 50% of revenues:
    • Alcohol
    • Gambling
    • Tobacco
    • Civilian firearms
    • Conventional weapons
  • 0% Controversial weapons
  • ≥ 6000 MW Nuclear power

ESG + ETFs = A Win for Fixed Income

The many benefits of ETFs – from instant diversification and ease of use to greater liquidity – are amplified within fixed income, which is where growth in ETFs has been most apparent for institutions. Since the Financial Crisis and regulatory changes such as the Volker Rule, reduced inventories have plagued fixed income desks globally, with less ability to support the marketplace. The uncertain environment with lower for longer bond yields, is perfectly aligned with ETFs, which are efficient to trade and low-cost to hold. These benefits are now combined with an ESG scope in BMO ESG Corporate Bond Index ETF and BMO ESG US Corporate Bond Hedged to CAD Index ETF, finally providing institutions with a fixed income approach that’s practical, strategic and – supportive of their values. BMO Global Asset Management’s ESG Fixed Income ETFs can provide significant exposure, diversification benefits, regular rebalancing, and ESG screening – all with one simple trade.

The ESG approach for the underlying issuers is similar to BMO MSCI Global ESG Leaders Index ETF, but with some minor differences to the MSCI Leaders Index, such as a minimum ESG rating of BBB (for more details, please refer to table below). For those institutional investors looking for a blend of equities and fixed income – together with ESG integration – BMO Balanced ESG ETF provides this diversified exposure, which is becoming increasingly relevant as a one-ticket solution.

Strategy Implementation for BMO’s ESG Fixed Income ETFs

Minimum ESG Rating

  • Minimum ESG rating BBB

Minimum Controversy Score

  • Excludes ongoing severe controversies

Weighting Scheme

  • Market value weighted
  • Rebalanced monthly

Exclusions

  • ≥ 5% of revenues:
    • Alcohol
    • Gambling
    • Tobacco
    • Civilian firearms
    • Conventional weapons
    • GMOs
    • Adult entertainment
  • >0% Controversial weapons
  • Nuclear power (utility, mining, designer, supplier)

Getting Ahead: Creating a Future with More ESG Options

Ultimately, ESG investing is more mainstream than it has ever been. In a world where macroeconomic trends have confronted us with unprecedented social, environmental and economic challenges, asset managers and investors are thinking ahead to create a sustainable financial system for the future.

As part of this progress, we have brought our full-service ethos into the RI arena, where BMO Global Asset Management has a longstanding track record of responsible investing for more than three decades. Adding ESG ETFs is a natural evolution given the backdrop: findings in a recent survey of 799 institutional asset owners, investment consultants and professionals in Canada, the U.S., Europe and Asia showed that despite the rise of ETFs as a trend globally, the overall average level of institutional ESG-based portfolios that is actively managed is 61%, suggesting there is ample room for ETF growth in this area.1 Meanwhile, a separate study found that 25% of institutions and 46% of asset managers have altered their portfolios by selling out of, or investing, into a specific strategy based on ESG considerations.3 These findings demonstrate the undeniable growing influence of ESG among institutional investors, and points to another potential driver for ETF growth in general.

The combination of active and passive management is one of our most important tenets as a global asset manager: our seven new ESG ETFs, including the first balanced ESG ETF in Canada are another efficient tool to help construct higher-quality portfolios that not only reduce risk and maximize performance, but also meet the diverse needs of institutions globally – personal values included.

 

To learn more about BMO Global Asset Management’s steadfast commitment to ESG investing – including its dedicated RI approach and breadth of active ESG funds – please contact your Regional BMO Asset Management Institutional Sales & Service Representative.


Also in the Winter 2020 Issue of IQ:

The Dawn of a New Decade: What’s Next?
Private Equity Growth at the Expense of Hedge Funds

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Disclosures

  1. Responsible Investing: An Evolving Landscape, RBC Global Asset Management. October 2019.
  2. Ibid.
  3. BMO Global Asset Management launched Europe’s first social and environmentally screened fund in 1984.
  4. Canadian Institutions Turn to ETFs in Challenging Markets, Greenwich Associates, Q2 2019.
  5. Ibid.
  6. Leveraging the Potential of ESG ETFs for Sustainable Development, United Nations, UNCTAD, November 2019.

 

Not intended for distribution outside of Canada.

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This communication is intended for informational purposes only and is not, and should not be construed as, investment, legal or tax advice to any individual. Particular investments and/or trading strategies should be evaluated relative to each individual’s circumstances. Individuals should seek the advice of professionals, as appropriate, regarding any particular investment. Past performance does not guarantee future results.

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