ESG Focus | Sep 09 2019
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The Rise Of The Vegan
A vegan ETF is the latest offering in a burgeoning US ESG-based investment fund market increasingly targeting every ESG theme from climate change to Christianity.
-Vegan ETF launches in US
-ESG-ETFs increasingly popular
-Not without risk
By Sarah Mills
This week, the world's first vegan-friendly and climate-conscious Exchange Traded Fund (ETF) launched on the New York Stock Exchange, perhaps the most promising ESG thematic ETF launched to date given its strong food and fast-moving-consumer-goods bias.
Titled the Vegan Climate Index, ticker VEGN, it is an ethical stock that offers investors a fossil-fuel free, agro-chemical free and plastic-free investment option. Compared with the unscreened Solactive US Large Cap Index, the Vegan Climate Index has 61% less carbon, 89% less waste and 83% less water in its footprint, according to Impact Cubed Squared.
The launch is timely. According to The Economist in an article titled ‘The Year of the Vegan', "2019 will be the year when Veganism goes mainstream." It was a sentiment reiterated in a Forbes article.
Millenials drive vegan trends
The Economist points out that a quarter of 25-34 year-olds in the United States say they are vegans or vegetarians. And where the millenials lead, business follows.
Global vegan meat-market sales hit $19.5bn in 2018, according to a report by Euromonitor International; the global vegan cheese market is forecast to hit $4bn by 2024, according to the Vegan Society; and meat substitute sales grew 451% in the European market in the four years to February 2018, according to the University of Hohenheim.
Transforming the food market
In 2040, it is estimated 40% of the global population will consume farmed meat, 35% will consume lab-grown meat and 25% will eat vegan replacements.
McDonalds now offers McVegan burgers, Ben and Jerry's offers vegan ice cream, KFC is offering vegan nuggets and burgers, dairy giant Danone recently invested $60m in dairy-free products, and plant milks are widely available in global supermarkets.
Veganism sits within the wider trend of health foods and organic produce, which has also been experiencing stellar growth – one only has to think of A2 Milk.
While vegans represent a relatively low percentage of the population (generally less than 1.5% in any given population, although Israel has the highest population at between 5% to 8%), vegan products have a general appeal to vegetarians, who comprise roughly 25% of the global market and are an obvious market for vegan conversion.
Regulators may step in
It seems veganism also stands to benefit from potential health regulation. The Los Angeles Schools District is now serving vegan meals in its schools, and several aged care institutions around the world are serving vegan menus to residents.
Like it or not, for ageing baby boomers, meat can be more hindrance than help and for institutions entrusted with residents' care, they may have a duty of care to make the shift. The American Medical Association recommended in 2017 that hospitals and medical associations should start serving vegan meals to patients.
There have also been some attempts to link veganism to climate change, with 24 EU members of parliament recently signing a letter requesting the EU move to a vegan diet to reduce greenhouse gas emissions. However, the science on this is in dispute.
Few arguments about personal care products
Less contentious than food or climate-change, however, is the potential market for fast-moving-consumer goods such as hair, facial, skincare and household cleaning products.
"Not tested on animals" is the most important packaging claim on personal care products for 57% of people. Beauty brands with cruelty-free certification account for 20% of women's face skincare products and the niche is growing at almost three times overall segment growth.
Launches for vegan facial and skincare products tripled between 2013 and 2018, growing from 13% of all launches in 2014 to 28% in 2018. Giant UK health beauty retailer Superdrugs' own-brand vegan cosmetics sale grew 750% in 2019. UK supermarket Tesco's sales of vegan cleaning products grew 80% in 2018.
A Market Research Future report predicts 6% sales growth for cruelty-free cosmetics between 2017-2023, and recent trends suggest this may be conservative.
The Vegan Trademark and accreditation scheme is well advanced and certification generally requires zero animal content (including vertebrates and invertebrates), zero animal testing, zero genetically modified organisms, and preparation standards wherein all vegan produce must be prepared separately and on separate surfaces and utensils.
But the crux of this story is not veganism, but ESG ETFs.
VEGN is a classic example of an ESG ETF
VEGN is a classic example of a thematic environmental governance and social (ESG) investing EFT, a group of investments that have experienced limited success to date.
Given past performance of thematic ETFs (ESG or standard), one could be forgiven for suggesting that those choosing to invest in a cause or a theme might be better served by a standard crowd-funder than a listed investment vehicle.
The above market analysis was primarily an exercise in determining whether VEGN has a better chance of escaping the fate of other ESG thematic ETFs, and if so, what characteristics might be those that can make the difference.
The FMCG link certainly increases VEGN's prospects markedly but much will depend on the direction in which funds are deployed. Investing in winning products or businesses could prove a boon, but using funds to force behaviours could be counterproductive.
If it is successful, it could prove a benchmark or model for future ESG thematic ETFs, and provide further direction for impact investing, vs exclusionary investing and best-in-class investing in the ETF field.
The underlying index targets mid-cap stocks in the hope that the sector will be more susceptible to leverage when the fund engages with its companies to remove animal products from business lines and improve vegan services. This reflects upon the fact that ESG thematic inflows are far too small to affect the behavior of large-cap companies. To date, the assumption that targeting mid-cap stocks may be a lever for revolution has yet to be tested.
Thematic ETFs and thematic ESG ETFs
VEGN is just one of many thematic ETFs to hit the market over the past decade. Typically, non-ESG ETF thematics have a strong technology bias, but the growing interest in ESG has recently witnessed a spate of environmental and social product launches.
Given its climate-conscious bias, VEGN falls squarely into ESG ETF territory. Morningstar says Information Technology is the number one ETF thematic, followed by the environment. Despite roughly $4 trn invested in ETFs only $13bn is invested in social investing.
ETF industry is booming
It is not surprising that ESG is pressing into the ETF space. The ETF industry is perhaps the greatest market success story in the past decade. Money has streamed from traditional investment vehicles such as mutual funds into ETFs.
Investors disillusioned by poor practices in traditional funds and high expenses have been lured by the low-fee exposure to baskets of stocks that offer a higher degree of liquidity, relative autonomy and set-and-forget appeal.
According to Independent ETF/ETP consultancy firm ETFGI, net global funds invested in ETFs hit US$5.74 trn at the end of July 31, 2019. US$60.19bn net inflows landed in July, (up1.7% on June) taking the yearly count to US$269.73bn. The trend shows no sign of slowing.
ETFs: Vanilla, thematic, factored or tailored
And investors are literally spoilt for choice. They can choose a vanilla ETF based on a basket of cross-industry stocks, in a geography or market; or a thematic, which could range from something as standard as gold and resources; to a niche thematic such as cybersecurity, cloud computing, AI or cryptocurrencies.
And then, to quote the old National Australia Bank tagline, ETFs offer "tailored solutions" to investors. ETFs are a factor investor's paradise.
Factor investing is a strategy that chooses securities based on attributes that are associated with higher returns. It is used to enhance diversification, generate above market returns and manage risk. There are two main types of factors: macroeconomic and style factors.
"The former captures broad risks across asset classes, while the latter aims to explain returns and risks within asset classes," says Investopedia. "Some macroeconomic factors include credit, inflation and liquidity, whereas style factors embrace style, value, and momentum, large cap vs mid cap, risk (beta)."
ESG ETFS factoring on steroids
And ESG and ETFs were made for each other.
Like standard ETFs, ESG ETFs can be divided into thematics along either environment, social, or governance lines (or all of the above). They are also structured along standard ESG investment lines, as in best-in-class, exclusionary, or "impact investing". Then they can also be structured along all the standard ETF factors mentioned above, such as value, quality, momentum, style and volatility. The permutations and combinations are mind boggling.
Both standard and ESG EFTs aim to outperform the market by reducing volatility or boosting returns, according to Bloomberg: "Both are quantitative strategies which means they can be recast as a rules-based index and tracked cheaply by ETFs.
Nir Kassair in Bloomberg Opinion, describes ESG investing as factor-investing on steroids – there are many individual factors within each of the ESG umbrellas and each of them can be expressed in a myriad of ways.
Enter tailored ESG solutions
Factor-investing can be a useful way for evaluating ESG ETFs. VEGN, as an example, is an exclusionary fund but it is also an impact fund, but its approach to volatility and returns is less clearly delineated. This mismatch can be a problem for ESG investors, but that is where the benefits of the ETF format become clear. Not only can investors gain access to a series of basket of stocks, they can tailor their own ESGs exposures according to either their investment or philosophical viewpoint, or both.
Open Invest Co and Ethic Inc, for example, are two funds that allow investors to customise their portfolios. This trend is likely to grow. One can envisage an investor taking a large stake in a best-in-class ETF and supplement it with interest-areas such as veganism or climate change, or Christian values.
As VanEck Vectors MSCI International Sustainable Equity ETF managing director Arian Neiron says in The Australian Financial Review:
"The beauty of the ETF format (for ESG investing) is that if you don't agree with a particular exclusion, for example stocks whose underlying business relies on genetically modified organisms, you can buy VanEck Vectors MSCI International Sustainable Equity ETF but then add GMO companies to your portfolio."
ESG ETF taking a larger slice of the pie
ESG investing is carving out its own slice of the burgeoning ETP/EFT market, as impact investors, exclusionary investors and best-in-class investors, all jostle to stake their claim.
The annual Brown Brothers Harriman ETF industry survey found investors were expressing a greater interest in ESG ETFs funds, 51% citing it as at least somewhat important, vs 37% last year.
According to Investopedia, this reflects on evidence showing that ESG investing is a viable long-term investment with the potential to outperform tradition investments. They are also gaining traction as investors seek to reduce the risk of stranded assets as the carbon war looms.
ESG ETFs to benefit from responsible investing trend
ESG investing is now as much about making money and minimizing risks as it is about doing the right thing. Nine out of 10 Australians expect their super to be invested responsibly and ethically, according to RIAA.
ETFs are likely to be the recipient of a large percentage of these funds. Responsible investing differs to ethical investing in that the former adheres to ESG data that shows clear links to risk-minimisation and long-term profitability. Ethical investing tends to be exclusionary. Often the two overlap, with an ESG and exclusionary screen being applied.
ESG ETFs on the rise
There are now roughly 50 major ESG ETFs trading on the US sharemarket and it is estimated that ESG assets generally could comprise up to two-thirds of assets managed by global funds by 2020.
According to Bloomberg, funds under management in ESG-focused ETFs hit a record $41.6bn, less than a third of the largest non-ESG fund.
In May, DWS launched the largest ESG ETF to hit the market in 15 years with fees as low as 0.11%, making it comparable with the most efficient vanilla ETFs.
Last year, Ossiam became the first European asset manager to launch a smart beta ESG ETF, which uses a machine-learning algorithm to rank companies based on their ESG status and financial potential.
It first applies an ESG filter to global large-caps and exludes all those that do not comply with the 10 principles of the UN Global Compact – and that's just the first filter.
MSCI boasts 1300 global institutional investors that use its ESG ratings and research, a trove that covers 650,000 securities and 8 million derivatives.
BNY Mellon believes this trajectory will continue and that ETFs may become the ESG vehicle of choice, given their transparency, low costs, and technological/research capital.
Niche ESG thematics on the rise
Most of the inflows into ESG ETFs to date have been the type that fit into the responsible investing category – let's call them vanilla ESG ETFs. They are typically low-fee funds designed to minimise carbon risk with a best-in-class focus.
But thematic ESG ETFs such as niche VEGN are also on the rise. VEGN is one of several to be launched in recent years.
California-based Inspire Investing launched a ESG ETF with Christian values as a screen, complete with tag line: "Do you invest like a Christian?" which belongs to the biblical investing social cohort. The Global X S&P 500 Catholic Values ETF proved the highest netting social ETF in 2019.
The Gender Diversity Index ETF ((SHE)) invests in companies that display gender diversity in boards and managements. Invesco Solar is one of the oldest thematic ESG ETFs, specialising in solar energy stocks. There's a Low Carbon Target ETF, a Fossil Fuel Reserves Free ETF, the Long-Term Care ETF, global infrastructure ETFs, Waste Collection, Recycling, Health, and Soil Remediation, just to name a few.
The most popular thematic ESG ETFS tend to focus on the environment, and the number of clean energy ESG ETFS has been rising by double digits.
Unicredit Bank has just listed two ex-Nuclear Power Multi Factor and Minimum Variance indices (the former is higher risk, the latter is lower volatility).
Most other thematic ESG ETFs have seen zero to negative flows so far in 2019, despite many boasting low expense ratios of 0.2%.
The potential for ESG thematics are endless: one can envisage legal ETFs that fund prospective lawsuits.
ESG ETFS have vastly varying risk profiles
Vanilla ESG ETFs – those focused on a best-in-class, broadly based index are designed to minimise risk, particularly carbon risk.
Not so thematic ETFs, which are generally exclusionary or based on positive-screening. The main risk is sector concentration. Environmental funds often display an overreliance on healthcare stocks and, more controversially, technology stocks, and the onus remains on the investor to check the underlying diversification in the ETF index.
ESG ETFs are less liquid than individual stocks, simply by the fact that there are less market makers per individual stock in the ETF. While the securities are sufficiently liquid under normal market conditions, the story can differ in a crash. Investors brought a class-action suit against Blackrock after a market decline in August, 2015, triggered trading halts and dozens of ETFs traded at sharp discounts to the sum of their holdings.
Then comes regulatory risk.
Still reeling from the securitisation-engineered global financial crisis, in which Europe fell foul of Wall Street's financial engineering practices, Europe has banned United States ETFs – a reflection of the separate regulatory environments governing the securities. Regulators across the world readily admit that they are playing catch-up with this rapidly growing market.
All the factor-investment potential mentioned above raises the spectre of the slicing and dicing that brought about the securitisation downfall. For example, A-REIT ETFs include mortgage pools as well as standard real estate.
Investors will need to ensure the underlying Index retains its integrity. Stocks in ETF indexes can change for any number of reasons.
Just last August, Vanguard eliminated a private prison operator GEO Group, a gun manufacturer Sturm Ruger, and Murdoch's media stocks, Yum Brands and GlaxoSmith Kline from its fund.
It was an error that caused these stocks to be included in the first place and highlights another risk: that ETFs and ESG funds failing to meet criteria could suffer reputation damage, or worse deal with regulators or lawsuits. Already several leveraged ETFs have suffered lawsuits relating to disclosure. The legal environment for ETFs is also evolving so investors cannot take anything for granted.
DWS Xtrackers S&P 500 ESG ETF ((SNPE)) tracks the S&P 500 ESG Index. S&P recently booted Facebook off for poor social and governance scores.
ESG ETFs also need to pass the consumer test. Greenwashing can be an issue, particularly for investors that are implementing an ESG screen to avoid risks surrounding stranded assets.
The onus remains heavily on the investor to vet the underlying stocks in the index, and monitor for changes.
Another interesting feature is that ETFs are allowed to lend their shares to other firms and earn interest. This adds another layer of complexity, as does the question of dividend payments.
There have also been instances in which management have stolen ETF funds.
The problems with ESG ETFs
Thematic ESG ETFs not only have all the standard risks of standard ETFs, they have their own subset that correlates closely to thematic ETFs. The strength of any ETF Index rests heavily on the research supporting the theme (more so than that needed for ESG best-in-class screens). This makes it hard to evaluate the robustness of the strategy and difficult to compare them with peers – that's assuming they even have peers.
Low success rate for thematic ETFs
About 35% of the thematic ETFs launched in Europe have already closed. This figure more than doubles for all thematics launched prior to 2012. Less than half of all equity ETFs have closed over the same period. History suggests that even if an investor clicks on to a winning theme, the funds don't survive long enough for them to benefit.
ESG thematic ETFs are typically more expensive than best in class
ESG ETFs are expensive. VEGN, for example, sports a total expense ratio of 0.6%. This compares with less than 0.1% for the largest standard ETFs, and less than 1.5% for large best-in-class and exclusionary ESG ETFs. Roughly 75% of ETF inflows have been allocated to funds with an annual expense ratio of 0.2% or less, and the average large cap smart beta ETF is about 0.3%, according to Investopedia.
One article speculated that this reflects the heavy level of upfront research required, and that the costs may ease as a fund gains traction. It points out that iShare slashed its expenses on several ESG ETFs in early 2019.
Can ESG ETFs change the world?
In the end, ESG thematic ETFs are all about changing the world – at their core is the seed of revolution. However, research shows that ESG inflows are so small that large-cap companies are unaffected by current investment levels and ESG thematic investing is unlikely to change their behaviour. That situation is unlikely to change within the next three years. In the meantime, investors can expect the smorgasbord of investment options to keep flowing.
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