Investing in stocks with ETFs? That's nothing new anymore. However, the topic of sustainability is becoming increasingly important in all areas. Many investors wonder if they might be supporting companies that generate a lot of CO₂ emissions, tolerate child and forced labor, or produce weapons with their current investments. Wherever you look, you can see that sustainability is playing an increasingly important role in the business world: food manufacturers are abandoning plastic packaging, companies are switching their fleets to electric or using only green energy. The financial sector has also discovered the topic of sustainability and now offers products classified as sustainable. Therefore, many investors are wondering if they could do something good with their money by investing it sustainably instead of supporting companies that do not operate according to sustainable criteria. The providers of ETFs have recognized this trend and have been offering sustainable ETFs for some years now.
However, many interested parties rightly wonder if these are really as sustainable as claimed. Furthermore, the market is teeming with various abbreviations and quality criteria that are difficult to separate from each other. Therefore, in this article, we will answer the six most important questions about sustainable investments with ETFs in more detail and approach this topic scientifically by first clarifying all the necessary basics and then going into detail on the topic.
What is an ETF?
ETF stands for Exchange Traded Fund. This means that we have a fund that is traded on the stock exchange. You can imagine this similarly to an index, such as the German stock index DAX, for example. This consists of the 40 largest stocks. An ETF therefore usually includes several individual values, but can be traded on the stock exchange just like a share. Its performance therefore depends on the performance of the individual values.
What does sustainability mean?
A sustainable development is a development that ensures the quality of life of the present generation and at the same time gives future generations the choice to shape their lives (Hauff 1987). Sustainability is to be understood in economic, environmental and social terms (Enquête Commission 1998 and the Sustainability Strategy at the Federal Statistical Office 2014).
The Duden defines the term as "the principle that no more should be consumed than can grow back, regenerate, or be provided again in the future". Simply put, we want to use the available resources responsibly so that future generations are not disadvantaged. Let's take the forest as an example. Sustainability here means that only as much wood may be harvested as can grow back. If more wood is harvested than the forest ecosystem can produce, the ecosystem is thrown out of balance. In recent decades, humans have not always adhered to these sustainability principles, so not only in the forest, but also in other areas we have been living beyond our means. That is why the sustainability debate is at the top of the agenda and is one of the megatrends of our time.
Today, every company must deal with sustainable action in order not to disappear from the market. This includes not only greenhouse gas-neutral energy production, but also avoiding plastic, causing less CO₂, fair working conditions, and many other criteria.
What does sustainability mean in the financial sector?
More and more people want to invest sustainably and ethically, or at least exclude certain companies or industries that they consider particularly critical. The major ETF providers are responding to these developments and are publishing more and more financial products that meet the wishes and expectations of investors. This development can also be seen in the absolute number of available sustainable ETFs. In mid-2018, there were only 49 ETFs in which one could invest in Germany. Today, according to justETF, there are already 283 sustainable ETFs (as of September 2022). Since December 2019, there has been an EU-wide regulation that regulates how sustainable financial products are classified. This is a major step forward, as there were very different views in the member states before the regulation about what is sustainable, what is ethically correct, and what is socially acceptable.
The best example to illustrate these different views is the different views on nuclear power in Germany and France. In Germany, nuclear energy is not counted among renewable energies because we still do not know where and how to store the radioactive waste from nuclear power plants. In addition, operating a nuclear power plant involves a certain residual risk for humans and nature. The situation in France, however, is entirely different. France sees nuclear energy as a completely climate-friendly way of generating energy, as hardly any greenhouse gases such as carbon dioxide (CO₂) are released during energy generation. However, it is precisely these different assessments and opinions that make it difficult to reflect these subjective requirements and wishes on the stock market. Therefore, various approaches and designations have established themselves in practice, which attempt to bundle the subjective perspectives in a product.
How to recognize sustainable ETFs
Over time, designations have emerged on the market that bundle certain exclusion criteria under a designation. These designations act like filters that only allow companies into the ETF that meet the sustainable, ethical, or social requirements. These designations usually exclude certain sectors in advance. These typically include alcohol, gambling, tobacco, armaments, civilian firearms, pornography, genetically modified organisms, coal-fired power, and so on.
One of the most common designations is: ESG, which stands for Environmental, Social, and Governance.
- Environment stands, among other things, for the efficient use of energy and resources, environmentally friendly production, lower emissions, comprehensive climate protection strategies.
- The social responsibility, or Social, includes compliance with labor rights and occupational safety, such as the prohibition of child and forced labor, discrimination prevention, as well as health protection and fair conditions in the workplace.
- And finally, the G stands for Governance, which can best be translated into German as corporate governance. It includes transparency in corruption and bribery prevention, linking executive compensation to sustainable corporate goals, general sustainable corporate strategies, handling whistleblowers, and so on and so forth.
In practice, ESG ETFs exclude certain controversial business areas, as we mentioned earlier. These ETFs are called screened. In another variant, not only are these controversial business areas excluded, but additional weight is placed on the interesting stocks. These are called enhanced. Companies with better ESG ratings are therefore weighted more heavily than companies with a poor score. Companies that have not been investigated at all or have received a rating that is too low are completely excluded.
Then there is the abbreviation SRI, which stands for Socially Responsibility Investing and means socially responsible investing. In connection with SRI, there is also often talk of Impact Investing, which means that such an investment should not only meet the return expectations but also sustainable goals. There is a clear focus on the social responsibility of companies. The SRI ETFs only pick out the absolute top candidates with the highest ESG ratings and bundle the best 25% from the benchmark index.
Advantages and disadvantages of sustainable ETFs
One of the biggest advantages is the feel-good factor. You want to be able to sleep soundly with an investment. However, we also want to achieve a certain return. Ideally, we can achieve both with sustainable investments. We are therefore investing in companies that use the invested money for something good.
The more people demand sustainable financial products, the more capital is tied up in them. The companies listed in the ETF can grow stronger with the additional capital, implement their projects, and thus contribute to solving various problems on earth. Other major investors will also gradually withdraw their funds from controversial business areas and shift them into more sustainable ones in the medium to long term. Thus, each investor has the chance to support only those companies with their money that are committed to sustainable goals.
At present, it can be assumed that sustainable ETFs do not have to accept significant returns losses and that the investment, whether sustainable or not, will achieve an almost identical return. Some analyses even go one step further and predict better performance compared to non-sustainable ETFs. However, this point should be taken with caution, as sustainable ETFs have simply not been around for long enough, and a comparison over several years is simply not yet possible.
Since the return of sustainable ETFs is almost identical to the performance of non-sustainable ETFs, the question arises as to why we should not invest sustainably if we have the choice. So let's take a look at arguments that could speak against sustainable ETFs.
The ESG ETFs are not as widely diversified as the parent index. However, we are only talking about around 10% fewer companies that the ETF replicates. With the SRI variants, the situation is quite different. Only about a quarter of the original number is included, which is at the expense of diversification and can thus potentially become a risk to performance, even if it has not yet been present.
Another point is the increased complexity of sustainable investment. We have noticed that there are many different categories and abbreviations, and there are also different ETF providers, some of which have different designations even though they mean similar things. Therefore, searching and researching at this point is likely to be more time-consuming and challenging than for comparable non-sustainable investments. In addition, the ESG criteria are sometimes applied differently, and therefore different companies achieve different ratings. Therefore, each investor must weigh up the advantages and disadvantages of sustainable ETFs for themselves.
There is no perfect sustainability when it comes to companies or indices. Rather, there are only certain sustainability ratings from different perspectives, where you have to inform yourself which of these ratings - or which index - best fits your personal beliefs. Certain indices may contain companies which, from your point of view, are not sustainable. A company may belong to the more sustainable half of companies, but does not act sustainably from your personal perspective. In addition, the sustainability boom can further increase greenwashing. Probably, more companies than ever will claim to be "sustainable", even though a detailed examination shows the opposite. Here, too, one must look individual and in detail.
Conclusion
Do not be under any illusion. Even with a sustainable ETF, it is not the perfect sustainable financial product. If it is important to you that your money really only goes to companies that you consider sustainable, it is quite likely that a sustainable ETF will not satisfy you. Because there are still too many companies included in the ETF that you do not find worthy of support. However, sustainable ETFs represent a good compromise. Especially if you do not have much time or are not motivated to examine each company in detail to invest in individual stocks, a sustainable ETF is a suitable solution. This way, you definitely invest more in sustainable companies than, for example, in less sustainable classic ETFs. In addition, one must be aware that the world will not be improved solely through our (passive) investment decisions. On the one hand, we must actively change our behavior and habits, and on the other hand, we must push for political changes to achieve long-term change. Sustainable investing remains a subjective matter. There is no right or wrong, you just have to bring it in line with yourself.