Varma & Ilmarinen: Bullish on ESG ETFs

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At least since the 2015 Paris Agreement on climate change and with the adoption of the 17 Sustainable Development Goals by the UN General Assembly, the need to direct capital towards sustainable investments has become a fact of life in financial markets. The UN-backed initiative Principles for Responsible Investment now counts with 3,830 signatories responsible for managing US$103.4 trillion in assets under management (AUM). The UN-convened Net-Zero Asset Owner Alliance now counts 35 asset owners among its ranks, representing US$5.6trn in AUM, committed to transitioning their portfolios to net-zero GHG emissions by 2050, consistent with a maximum temperature rise of 1.5°C above preindustrial temperatures.

However, how such funds will pour into sustainable projects isn’t entirely clear. Increasingly, evidence suggests ESG-themed exchange-traded funds (ETFs) are becoming a preferred channel for sustainable investments as they provide a low-cost and easily accessible solution to ESG-risk mitigation. Insights from Finnish asset owners suggest that global trends are reflective of on-the-ground experience in the Nordic country.

ESG ETF Market Trends

According to an August 2020 report by Invesco, which surveyed 101 European institutional investors, 21% of ESG assets were invested passively via ETFs. Moreover, 45% of all respondents reported they intend to increase their exposure to ESG ETFs in the next two years, while only 5% plan to decrease it. The shift appears to be motivated by a belief that ESG assets are likely to provide better returns than other assets, with 60% of respondents stating that they believe that ESG ETFs are likely to outperform traditional non-ESG benchmarks, even in normal market conditions. The pandemic also played a role in investors’ perspective with 68% of the institutional investors surveyed expressing a belief that COVID-19 will accelerate ESG investments.

A subsequent survey of 320 global professional investors published by JP Morgan Asset Management in its Global ETF Study 2020 confirms these trends. While on average 51% of all respondents expected strong growth, only 45% and 35% of USA-based and Latin American investors agreed, while 63% and 50% of EMEA and Asia Pacific investors agreed, respectively.

Data from TrackInsight reports that the global ETF market ended 2020 at a record high of US$7.6 trillion in AUM, across 6,518 ETFs. Of this total, 671 ETF managed US$204.8 billion worth of ESG assets. By the end of the first quarter of 2021, that figure had already increased by 27.8% to US$264.4 billion thanks to the entry into the market of another 87 ESG ETFs.

Geographically, TrackInsight shows that despite the general resistance patent in other surveys, flows into ESG ETFs registered in the Americas (with US$98.6 billion in AUM) do come second to their European counterparts (with US$161.3 billion in AUM) with flows into Asian and Pacific countries (APAC) coming a distant third (with US$4.5 billion in AUM). The data platform also shows that three goals dominate asset alignment with the UN’s Sustainable Development Goals (SDGs): Climate action (SDG 13), Affordable and clean energy (SDG 7) and Industry, innovation and infrastructure (SDG 9).

ESG ETFs and Finland’s Pensions

Finland’s experience with ESG ETFs appears to echo those global trends. To understand the local market better we approached Varma and Ilmarinen, two of the country’s largest pension companies.

Varma invested approximately €4 billion in ESG ETFs. These include at least two ETFs worth €200 million and €500 million, launched in September and December 2019, with Legal & General Investment Management (LGIM) focusing on European and US equities, respectively. Both ETFs take sustainability criteria into consideration and apply a broad range of exclusions. Most recently, Varma announced a €200 million investment in BlackRock’s U.S. Carbon Transition Readiness ETF to support companies lowering their CO2 emissions and reduce the footprint of its own investments. The ETF listed on the New York Stock Exchange on April 8th, 2021, for €1 billion, making it the largest ETF launch ever.

Juha Venäläinen, Senior Portfolio Manager at Ilmarinen

The situation was similar at Ilmarinen, which oversees €53.3 billion in pension assets, of which €5.2 billion were invested in 15 different equity ETF funds with another €385 million in one fixed income ETF. According to Juha Venäläinen, Senior Portfolio Manager at Ilmarinen, “over 90% of the assets in equity ETFs were held in ESG ETFs.” Indeed, five ESG ETFs from Amundi, iShares, Lyxor and Xtrackers account for approximately €4.9 billion. “All the funds have been great investments”, Venäläinen says, noting no significant differences in performance.

Strategic Goals and Challenges

Hanna Kaskela, Director for Responsible Investments at Varma

Varma and Ilmarinen appear to use ETFs to strategically mitigate ESG risks. “Varma’s Climate policy of investments defines strategic targets also for ETFs. Current target for low carbon ETFs is 35% 2025. We are very confident that we will achieve that already this year,” says Hanna Kaskela, Director for Responsible Investments at Varma. “ETFs should be in line with our climate policy. They should not invest in companies that violate global norms like UN Global Compact and don’t invest in tobacco and controversial weapons,” Kaskela explains.

“By using ESG ETFs, our passive investments are filtered through ESG screens. ESG screens reduce ESG related risk vs broad index ETF. The ESG risks become more likely when ESG & climate awareness is growing. The changes in regulations, taxations and consumer behaviour will all favour companies that take ESG issues seriously,” Venäläinen explains.

Although Kaskela focuses on the challenges posed by liquidity and data, Venäläinen highlights stewardship challenges in ETFs. “The Stewardship process is a factor in ESG ETFs when comparing  the broad index ETFs,” Venäläinen explains.“The size and liquidity of the ETFs can be a challenge,” Kaskela says before noting that the inherent ambiguity of sustainable investments can lead to a degree of confusion where “the interpretation of ESG may differ” from one asset manager to another. Moreover, she also note that “in general ESG data is a bit too much backward looking and if there are some forward looking ESG data (like emission reduction targets, companies which benefit from climate change mitigation) that an ETF uses then I would say it’s getting more aligned with traditional investment data.”

Going forward Kaskela is optimistic about the rise of ESG in passive investments. “The passive side of the capital markets need also to be more ESG compliant. There seems to be change happening.” Given the significant proportion of ESG ETFs in Ilmarinen’s portfolio, it seems unlikely it will change much, according to Venäläinen. That being said “we look at the market and search for opportunities but at the moment we see nothing immediate there,” he concludes.

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