Sustainable ETFs Explained

See how sustainable investing works, including ESG ratings and the top sustainable ETFs.

kent
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Research Lead
Reviewed by: Kent Thune
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Edited by: Kent Thune

In recent years, there has been a growing interest in sustainable and responsible investing, as more and more investors are seeking to align their investments with their values. This has led to the growth of ETFs that focus on environmental, social and governance (ESG) criteria.

These ESG ETFs, also known as sustainable ETFs, offer investors a means of potentially generating returns while gaining exposure to companies that can make a positive impact on the world. 

What Are Sustainable ETFs? 

Sustainable ETFs are exchange-traded funds that invest in a basket of companies that are leading the way in sustainability, while also adhering to strict ESG criteria. These ETFs typically invest in companies that have demonstrated a commitment to reducing their carbon footprint, promoting diversity and inclusion, and following ethical business practices.

In addition, sustainable ETFs also screen out companies that are involved in controversial practices, such as the production of fossil fuels or the manufacture of tobacco products. 

Pros and Cons of Investing in Sustainable ETFs 

There are several potential factors that might influence an investor to invest in sustainable ETFs, including the opportunity to invest in companies that are making a positive impact on the world. But like any investment, sustainable ETFs come with certain risks. Before buying shares, investors should weigh all the pros of cons of investing. 

The Pros of Investing in Sustainable ETFs 

  • Moral benefits: By investing in companies that are working towards sustainability, investors can feel good about the impact their investments are having on society and the environment. 
  • Potential for higher returns: Studies have shown that companies that are committed to responsible business practices are often more profitable and better managed than those that are not. This is because companies that prioritize ESG criteria are more likely to have a long-term perspective and are less likely to engage in risky or unethical practices that could harm their reputation and financial performance. 
  • Diversification: This can be especially important for investors who are looking to invest for the long term, as it helps to minimize the impact of any individual company's performance on the overall portfolio. 

The Cons of Investing in Sustainable ETFs 

  • Higher fees: Due to the additional costs associated with screening companies based on ESG criteria, some sustainable ETFs have higher expense ratios than traditional ETFs.
  • Higher potential risk: Some sustainable ETFs may invest in companies that are less established or that have a smaller market capitalization, which can increase the risk of the ETF underperforming in times of market volatility. 
  • Inconsistency: Performance of sustainable ETFs can be affected by changes in the ESG landscape. For example, a company that is considered to have strong ESG practices today may find itself facing negative publicity or regulatory actions tomorrow. Also, ESG criteria used by different sustainable ETFs can vary significantly.

How to Choose the Best ESG ETFs 

Researching and analyzing ETFs can be a complex process, but it’s important to consider the following factors for choosing the best ESG ETFs: 

  • Investment objectives: The first step in choosing the best ESG ETF is to determine your investment objectives. This will help you identify the type of ETF that is aligned with your investment goals, such as long-term capital growth, income, or a combination of both. 
  • ESG methodology: Different ESG ETFs may use different methodologies to determine a company’s ESG profile. Some may focus on environmental sustainability, while others may focus on social and governance issues. It is important to understand the ESG methodology used by the ETF and how it aligns with your values and beliefs. 
  • Portfolio composition: ESG ETFs may have different portfolio compositions, and it is important to consider the industries and companies in which they invest. Some ETFs may focus on a specific industry, such as renewable energy, while others may have a broad portfolio that includes companies from a variety of industries. 
  • Expense ratio: The expense ratio is a measure of the annual costs associated with managing an ETF, and it is important to consider when choosing the best ESG ETF. A higher expense ratio can reduce the returns of your investment over time. 
  • Historical Performance: While past performance is not a guarantee of future results, it can be helpful to review the historical performance of ESG ETFs to see how they have performed in different market conditions. This can help you determine if the ETF has a track record of delivering consistent returns over time. 
  • Liquidity: It is also important to consider the liquidity of the ETF when choosing the best ESG ETF. A more liquid ETF is easier to buy and sell, and it is less likely to experience large price swings in a short period of time. 
  • Diversification: Diversification is key to a successful investment strategy, and ESG ETFs can provide a way to diversify your portfolio by investing in a range of companies and industries. However, it is important to consider the level of diversification offered by the ETF and whether it aligns with your investment objectives. 

In conclusion, choosing the best ESG ETF requires careful consideration of investment objectives, ESG methodology, portfolio composition, expense ratio, historical performance, liquidity and diversification. By considering these factors, investors can make informed decisions while aligning beliefs and values with investment goals. 

How Do ESG Ratings Work? 

Environmental, social and governance ratings are evaluations of a company's performance on non-financial criteria that are becoming increasingly important for investors. The ESG ratings assess how well a company is managing risks and opportunities in the areas of environment, social responsibility, and corporate governance.

Many investors use ESG ratings as a key consideration in their investment decisions, as ESG risks and opportunities can have a significant impact on a company's financial performance and long-term prospects. ESG ratings also provide a valuable tool for companies to assess and improve their ESG performance, and to communicate their progress to investors and other stakeholders. 

ESG ratings are usually performed by independent rating agencies and can be used by investors to identify and compare companies based on their ESG performance. Thus, these ratings can provide an integrated view of a company's overall performance and can help investors assess the sustainability and long-term value of their investments. 

ESG ratings factors include: 

  • Environmental: These factors include a company's impact on the environment and its sustainability practices, such as reducing carbon emissions, preserving natural resources, and developing products and services with a positive environmental impact.
  • Social: These factors include the company's relationships with stakeholders, such as employees, customers, and communities, as well as its diversity and inclusion practices, human rights policies, and labor relations. 
  • Governance: These factors cover the company's leadership, accountability, and control mechanisms, such as the composition and independence of the board of directors, executive pay and shareholder rights, and transparency and ethics in decision-making.

ESG ratings provide a comprehensive evaluation of a company's non-financial performance, and they are becoming increasingly relevant for investors seeking to understand the sustainability and long-term value of their investments. ESG ratings are an important tool for companies to assess and improve their ESG performance, and to communicate their progress to investors and other stakeholders. 

5 Top Sustainable ETFs by AUM 

The five top sustainable ETFs, as measured by assets under management, are: 

  1. iShares ESG Aware MSCI USA ETF (ESGU): This ETF tracks an index composed of U.S. companies that are selected and weighted for positive environmental, social and governance characteristics. Companies in the broad MSCI USA Index are rated based on ESG factors and are narrowed down by excluding companies involved in tobacco, controversial weapons, civilian firearms, thermal coal, and oil sands. 
  2. iShares ESG Advanced MSCI EAFE ETF (ESGD): This ETF invests in companies based in Europe, Australasia, and the Far East (EAFE) that have a strong ESG profile, as determined by MSCI ESG Fundamentals. The ETF seeks to track the performance of the MSCI EAFE ESG Advanced Index. 
  3. iShares MSCI USA ESG ETF (SUSA): This ETF invests in large and mid-cap U.S. companies that have a strong ESG profile, as determined by MSCI ESG Fundamentals. The ETF seeks to track the performance of the MSCI USA ESG Select Index.
  4. Xtrackers MSCI USA ESG Leaders Equity ETF (USSG): This ETF invests in U.S. companies that have a strong ESG profile, as determined by MSCI ESG Fundamentals. The ETF seeks to track the performance of the MSCI USA ESG Leaders Index. 
  5. Invesco Solar ETF (TAN): This ETF invests in companies involved in the production and distribution of solar energy products and services. The ETF seeks to track the performance of the MAC Global Solar Energy Index. 

It's worth noting that the AUM and the composition of these ETFs can change over time and may have different rankings based on the current market conditions and evolving corporate cultures. 

Bottom Line 

Sustainable ETFs, also known as ESG ETFs, offer investors a convenient and accessible way to invest in companies with strong ESG ratings. By investing in ESG ETFs, investors can align their investments with their values and potentially achieve their financial goals while making a positive impact on the environment and society.

However, like any investment, sustainable ETFs and other ESG funds carry certain risks, and it’s important to carefully consider the pros and cons of investing before buying shares. 

Kent Thune is Research Lead for etf.com, focusing on educational content, thought leadership, content management and search engine optimization. Before joining etf.com, he wrote for numerous investment websites, including Seeking Alpha and Kiplinger. 

 

Kent holds a Master of Business Administration (MBA) degree and is a practicing Certified Financial Planner (CFP®) with 25 years of experience managing investments, guiding clients through some of the worst economic and market environments in U.S. history. He has also served as an adjunct professor, teaching classes for The College of Charleston and Trident Technical College on the topics of retirement planning, business finance, and entrepreneurship. 

 

Kent founded a registered investment advisory firm in 2006 and is based in Hilton Head Island, SC, where he lives with his wife and two sons. Outside of work, Kent enjoys spending time with his family, playing guitar, and working on his philosophy book, which he plans to publish in the coming year.