Two unrelated recent announcements heralded the arrival of Exchange Traded Funds to the world of sustainability investing. While this development represents another symbolic step in the mainstreaming of sustainability investing, the value – to advancing sustainability or investor returns – is much less clear.

In May, Pax World Investments announced the ESG Shares, passively-managed Exchange Traded Funds tracking three well-known sustainability indices:

  • the FTSE KLD North America Sustainability Index, a broad-based, sector neutral index of US and Canadian companies rated as providing superior ESG performance by KLD Research & Analytics, a well-respected firm with 20 years in SRI/ESG investment research
  • the FTSE KLD Europe-Asia Pacific Sustainability Index, a similar index from KLD covering that geography
  • the FTSE ET50 index of the fifty largest global pure-play companies in sustainable technologies

In mid-June, Huntington Asset Advisors filed a request with the SEC requesting permission to offer two actively-managed Exchange Traded Funds. One of those, the proposed EcoLogical Strategy Fund, would focus on capital appreciation, investing in equity of domestic and foreign companies of all sizes that “satisfy one or more environmental themes”.

Both actively-managed and passively-managed ETFs pose some interesting challenges for sustainability investing. These potential pitfalls are due to the nature of ETFs themselves and to the application of a concept like “sustainability” to this financial construct. (A refresher on ETF structure and characterstics is here.)

For passively-managed funds, one challenge is always the index itself.  Investment professionals spend a lot of time worrying about whether their funds actually perform the way the theoretical “index” would.   Although ETFs have an advantage over mutual funds in that they do not have to hold significant amounts of cash as they do not face the frequent and unpredictable cash sales and redemptions that mutual funds do, they still have to deal with changes in the index and other transactional issues.   Further, many funds are built by “sampling” the investments in the index rather than replicating them exactly, further complicating the challenge of matching the index’s performance.

Activist ownership is a significant element of sustainability investing for many investors and investment managers in the field.  By definition, a manager replicating an index can not be an active owner.  As long as a company is in the index, the manager must hold that company.   And when the index changes, the manager must divest that holding.

Another, more significant, challenge for passively-managed sustainability funds is the nature of a specialized index.  The original idea behind an index fund was to provide low-cost diversification that would perform in line with a larger, representative asset class.   But a lot of judgment is required to created a sustainability index (the same is true of many specialized indexes). Can that truly represent a passive investment?

Sustainability is a complex and nuanced topic, covering a very broad spectrum of industries. Under most definitions, qualifying as sustainable is more dependent on company behavior and business practices – which can and do change – than on core characteristics that are most often used for specialized indexes (for example, industry, sector, size, geogrpahy). Specialized indexes are frequently disproportionally weighted by a few stocks, which can certainly affect performance and representativeness.

Actively-managed ETF’s would seem to address that issue, but come with their own set of thorny problems.

  • Stretching the bounds of the concept – While perhaps not an oxymoron, “actively-managed” is certainly a reach from the original purpose behind the creation of ETFs as a low-cost way to provide diversification for smaller investors. This should be a red flag – or at least a yellow caution flag. Innovative financial instruments taken way beyond their original purpose are a prominent feature of almost every financial crisis or disaster.
  • SEC Exemption from securities law provisions is required – The SEC must grant an exemption to provisions of security laws for the creation of an “actively-managed” ETF. (The filing by Huntington with the SEC is that waiver request.) That requirement, plus the complexity of setting up the fund, means that it can take six months to year after the filing before an actively-traded fund is up and running.
  • Amplification of risks arising from ETF structure – the potential risk to investors from front-running, free-riding, and conflicts of interest inherent in the structure of an ETF are heightened for actively-managed funds. A significant part of the SEC filing for an actively-managed ETF should address those concerns.

The impact of those concerns is evident in the size of the market. At the end of 2009, there were only 21 actively-managed ETFs among the 797 funds in existence. Those funds only managed about $1 billion (0.13%) of the $777 billion in ETF assets.

So while these new funds are in the abstract a welcome development for sustainable investing, a careful, clear-eyed consideration of the potential issues should precede any rush to embrace this approach as a significant opportunity for growing sustainable investing. That caution applies as much to the investment managers creating these products as to the potential investors in them.

Sustainability investing – Exchange Traded Funds arrive