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(Bloomberg) — One of the world’s biggest synthetic exchange-traded funds is starting to look like exhibit-A in the latest controversy to hit ESG ratings.
The $15 billion ETF, which is managed by Invesco Ltd., uses swaps to offer clients exposure to the S&P 500. The ETF currently has a AA rating at MSCI ESG Research, the biggest provider of such scores. Under European Union rules, however, the fund is registered as Article 6, meaning the product doesn’t target any environmental, social or governance goals.
The absence of consistency in ESG classifications shows the hurdles investors face when trying to allocate capital. Though Invesco hasn’t registered its synthetic ETF as an ESG product, the fund now sits in at least three other portfolios that claim to “promote” ESG in Europe, according to data compiled by Bloomberg.
Against that backdrop, MSCI said last week that it’s planning to dramatically cut back the number of funds to which it assigns top ratings. The review was triggered by feedback from MSCI’s clients, including Invesco. Across all public fund categories, 31,000 now face ESG ratings downgrades, with the proportion of AAA funds set to plunge to 0.2% of the total from roughly 20%. AA funds will contract to make up about 22% of the universe from 33%.
For swap-based ETFs such as the Invesco fund, MSCI is changing its methodology to move away from scores that reflected the characteristics of a synthetic fund’s collateral to instead look at the constituents of the underlying index being tracked. Though MSCI has made clear there will be far fewer top-rated funds, it hasn’t made public how individual products will be affected.
It’s the latest headache to descend on the market for ESG investing, where existing classification systems are facing serious questions. In Europe, the fund industry ended 2022 by stripping the highest ESG tag off €175 billion ($190 billion) worth of client assets, with analysts predicting more to come. The upheaval has led the EU to reconsider its ESG investing rules, and explore major changes to fund labels.
Chris Mellor, head of EMEA ETF equity product management at Invesco, said MSCI’s current methodology measures something that “has no real relevance for the performance of the ETF.” He expects the proposed changes to improve the reliability of MSCI scores.
What MSCI ESG Research Says…
“MSCI ESG Research is implementing a solution to rate swap-based funds based on the exposure of the fund to underlying index constituents (rather than the collateral), to better reflect the funds’ exposure to ESG risks and opportunities. This solution will enable MSCI ESG Research to continue coverage of swap-based funds by extending the current data submission model with fund managers to provide us with the underlying constituents of the replicating index,” the company said in an email to clients seen by Bloomberg News.
Mellor said it makes sense to assign swap-based ETFs ESG ratings, provided the methodology holds up.
“If you think about what the ESG rating is telling an investor, it’s telling them what the risks are to that investment from an ESG perspective,” he said. “That will affect the performance of a synthetic ETF in exactly the same way as it would affect the performance of a physically replicating approach. So, it is as relevant for a synthetic as it is for a physical fund.”
The Invesco product is far from an isolated example. In fact, nine of the 10 biggest synthetic ETFs registered in Europe currently have ESG ratings of at least AA at MSCI, Bloomberg data show. At the same time, all are listed as Article 6, meaning they don’t market themselves as ESG. MSCI’s changes are due to take effect at the end of April, according to the company.
In response to a European Commission consultation on ESG ratings, MSCI has suggested investors are better served if ratings models are diverse.
“Today, the lack of uniformity in ESG ratings is often described as a weakness; we believe it demonstrates the diversity of opinions and methodologies. By analogy, there would be limited utility if all investment advisers came to the same buy/sell/hold determinations in their assessments of securities. Dispersion of views and approaches demonstrates a dynamic and competitive market where investors have choices to select providers that reflect their perspective or multiple providers that provide varying and diverse inputs. A mandated one-size fits-all approach to ESG ratings would reduce the thoroughness, innovation, effectiveness and evolution of the ratings,” MSCI said in June.
Assigning ESG ratings to synthetic ETFs is a controversial step in itself. Other ESG score providers have shied away from trying to assess the sustainability of products that are based on derivatives.
After debating the issue a few years back, Sustainalytics parent Morningstar Inc. decided that whether a ratings methodology was based on collateral or underlying indexes wasn’t really the issue, said Hortense Bioy, the firm’s global director for sustainability research.
“Both options had flaws and the potential to mislead investors,” she said. “So we don’t assign ESG ratings to synthetic ETFs.”
ISS ESG, another competitor to MSCI, said few swap-based ETFs would be rated within its methodology.
“To the extent we cover synthetic ETFs, we do so on the basis of the actual holdings, not on the basis of the index they are tracking,” said Till Jung, managing director and global head of ESG products at the sustainable investment arm of Institutional Shareholder Services.
Invesco, which offers a total of 62 synthetic ETFs with more than $30 billion of client assets according to Bloomberg data, only markets one as having any ESG attributes.
“If there’s scary things in the basket, then I’m making a mistake,” Mellor said. “The approach we take is to ensure that the collateral basket restrictions are aligned with the restrictions of the index itself. We also apply some additional constraints around ESG score, and so on.”
Amundi SA, whose owner Credit Agricole SA is the biggest provider of swap-based ETFs in Europe with well over $70 billion in client assets according to Bloomberg data, says investors shouldn’t rely on a single ESG ratings provider when deciding how to allocate their money.
“Third-party fund ratings help investors compare different products using the same methodologies,” but “changes like this show the issues that reliance on one data vendor can bring,” said an Amundi spokesperson. “Amundi works with several data providers and uses its own scoring methodology and due diligences to assess issuers and funds’ ESG characteristics.”
Meanwhile, the ESG ratings industry is facing a crackdown from policymakers across jurisdictions. The European Commission is planning to unveil new industry rules in the first half of this year. And the UK has just launched a consultation on the extent to which ESG raters need to be reined in by clear rules.
(Bloomberg LP, the parent of Bloomberg News, also provides ESG scores.)
–With assistance from Akiko Itano, Amine Haddaoui, Carlo Maccioni and Sam Potter.
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