The rise of ETFs and ESG investing – what investors need to know

An Exchange Traded Fund (ETF) is a basket of investments that usually includes shares or bonds, run by a professional fund manager. They normally provide access to a diversified portfolio for usually a much lower cost than buying the individual investments yourself.

Most ETFs track an index – a collection of securities that represent a certain sector or region. For example, the FTSE 100 is an index that represents the biggest 100 companies in the UK. When you buy an ETF, you’re buying a slice of the ETF’s underlying portfolio.

Find out more about ETFs

You can read more about ETFs on our research page.

What is ESG?

ESG is an investment approach where investors consider Environmental, Social and Governance factors as part of their wider research. They might think about issues like whether the company effectively manages its carbon emissions or whether it treats its customers, staff and suppliers well. But it can also include things like whether senior managers are incentivised appropriately.

A growing industry?

In 2003, there were only 291 ETFs around the globe on offer to investors. Now, there are nearly 9,000 offering a diverse range of investment opportunities.

Unsurprisingly, the US forms the biggest chunk, with nearly 31% of the total ETFs globally. But Europe’s not far behind accounting for around 22% of the market.

ESG ETFs are stepping into the spotlight

There’s also been an acceleration in investor interest in ESG ETF products. In fact, ESG ETFs represented 42% of total European ETF flows in the three months to the end of June 2022.

This has been driven by the emergence of specialist benchmarks like the Paris Aligned Benchmark and Climate Transition Benchmark. These indices let you invest into passive carbon reduction solutions.

ESG funds have also enjoyed the tailwind of European regulation which has directed capital into sustainable and ESG funds. For example, financial advisers now need to consider their clients’ sustainability preferences, alongside their financial objectives.

As ETFs have historically taken a passive approach (tracking instead of trying to beat the market), investing in ESG themes through this wrapper is blurring the divide between passive and active. Fund managers are also increasingly expected to be active owners and engage with the fund’s underlying companies to improve their ESG credentials.

What have we seen among our clients?

We’ve seen a similar trend to what’s echoed across the industry. Since January 2017, the number of HL clients holding ETFs in their accounts has increased almost 80%, from 5.1% of the total client base to 9.1% as of June 2022. The proportion of clients holding ESG ETFs has grown nearly 708%, from 0.13% to 1.05% over the same period.

Proportion of HL clients holding an ETF

Scroll across to see the full chart.

How do ESG ETFs fit into a responsible portfolio?

Before investing, it's important to consider your goals. If you're investing for ten years or more, you could think about taking a little more risk and investing a bigger part of your portfolio in share-based investments. Taking more risk could mean you see some big swings in the value of your investments, so make sure you’re comfortable – you could get back less than you invest.

When it comes to building a responsible portfolio itself, we think a core-satellite approach is an option for most investors. The core usually forms the bulk of the portfolio and is usually made up of a number of funds. It’s complemented by smaller 'satellite' investments, possibly in higher-risk areas. We think any satellite investment should usually only form a small part of a well-diversified portfolio.

A core holding could be a diversified global ESG tracker for example, which acts as part of the backbone for a responsible portfolio.

When considering ESG in a responsible portfolio, it’s not just about managing risk. It can also help highlight opportunities too.

For example, an ETF focused on carbon reduction will have exposure to companies making more progress reducing carbon emissions than most of the other companies in its industry. These businesses are less likely to be impacted by future climate policies and carbon taxes, and are more likely to be exposed to the opportunities of the low carbon economy such as government incentivisation.

Please note, only investing your portfolio in one sector, for example renewable energy, could leave you at risk if that sector falls out of favour.

This article isn’t personal advice. If you’re not sure if an investment is right for you, ask for financial advice.

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Our ETF research is for investors who understand the risks of investing and that investing in ETFs isn't right for everyone. Investors should only invest if the ETF's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of an ETF before they invest, and make sure any new investment forms part of a diversified portfolio.