Under the hood of Australia’s largest sustainable ETF

Australia’s largest sustainable fund easily outpaces the ASX 200 and boasts strict exclusion criteria, but there are companies accused of tax evasion among its holdings. The results illustrate the challenges investors face in the broader sustainable or ethical investing space, where definitions can vary from fund to fund.

BetaShares Global Sustainability Leaders ETF (ASX:ETHI) has more than $1.3 billion under management. It tracks an index of large global stocks identified as “Climate Leaders”, companies that have also passed several exclusion tests, including involvement with fossil fuels, weapons, and human rights abuses.

Sustainable funds like ETHI are growing in popularity. Assets in Australian sustainable funds topped $25 billion in 2020, with $4 billion over the year.

Interest in sustainable investment has come alongside concerns about “greenwashing”, whereby funds or companies convey a misleading impression about their environmental credentials. In March, the European Union introduced new rules to make sustainable financial products more consistent and transparent.

ETHI’s holdings pass some of the strictest exclusion tests in the industry. Sectors such as fossil fuels, weapons, pornography, and factory farming are excluded, although the fund counts among its holdings companies, such as Activision Blizzard (ATVI), that have been fined for tax evasion.

The fund’s definition of “climate leadership” means many of the holdings, such as Big Pharma or the credit card majors, are not directly involved in ethical or sustainable activities.

Is Mastercard (MA) a sustainable investment? It depends what an investor means by sustainable.

Below, we dig into the fund to help investors understand where their money is going, and the prospects for this popular and important space.

Building a sustainable fund

ETHI tracks an index of 200 companies, the Nasdaq Future Global Sustainability Leaders Index. The index is jointly created by Nasdaq and BetaShares.

The index is populated through a three-step process. First comes a $2 billion market cap minimum and trading liquidity requirements. Next, firms must qualify as “climate leaders”, with a carbon efficiency score, defined as greenhouse gas emissions divided by annual revenues, in the top third for their industry, or superior performance on Scope 4 carbon emissions, defined as avoided emissions.

A third stage excludes sectors by ESG criteria. Companies involved in fossil fuels, weapons, live animal exports, factory farming, detention centres, or pay-day lending? Gone. Companies with more than 33 per cent of revenue from junk food production? Gone. No women on boards? Gone.

An external three-person Responsible Investment Committee (RIC) determines the final list. The RIC actively monitors ESG-related controversies, says Cameron Gleeson, senior investment specialist at BetaShares.

"The RIC has monthly screens for controversies and engages with those companies where they believe it is required," he says.

"The RIC can exclude a company if an alteration in behaviour is not evident."

In 2018, the RIC removed Facebook from the fund over data privacy concerns.

ETHI is Australia’s largest sustainable exchange traded fund measured by net assets. It is followed by Vanguard’s Etclly Cons Intl Shrs ETF (VESG), a currency hedged version of ETHI (HETH), and VanEck Vectors MSCI Intl Sust Eq ETF (ESGI).

Credit cards, pharma, and HR software

ETHI’s strict exclusion criteria leave the portfolio with no exposure to the fossil fuel sector. But as per the fund’s definition of “climate leadership”, many of the holdings’ core businesses have little to do with climate or environmental sustainability beyond reducing their own emissions.

Technology and financial services make up 52.73 per cent of the fund. This rises to 81.49 once healthcare and consumer companies are included.

Financial services holdings are dominated by credit card providers (12.55 per cent) and insurers (7.95 per cent). Visa (V), Mastercard, and American Express (AXP) make up 8.23 per cent of the fund’s portfolio.

The fund’s portfolio includes 8.9 per cent spread across 19 enterprise software providers, covering everything from cybersecurity, to cloud computing, to specialised software for financial services.

Pharmaceutical giants total 3.03 per cent of the holdings, with Roche (ROG) at 1.11 per cent; Sanofi (SNY) at 0.76; GlaxoSmithKline (GSK) at 0.41 per cent; AbbVie (ABBV) at 0.75 per cent.

The top three holdings as of 30 April were iPhone maker Apple (AAPL), chipmaker Nvidia (NVDA), and electric vehicle manufacturer Tesla (TSLA).

The top 10 holdings of the three major sustainable funds are shown below, with crossholdings highlighted in matching colours.

Sustainable funds, top ten holdings

Source: Morningstar Premium, VESG as of 31 Jan, ETHI as of 30 April, ESGI as of 5 May

Strong performance

ETHI’s return of 21.88 per cent since its inception in January 2017 is impressive. By comparison, over the same period SPDR S&P/ASX 200 ETF (STW) returned 8.82 per cent.

The fund’s best year was 2019, where it returned a mouth-watering 35.60 per cent.

Helped by its holding in Tesla, the fund stormed to a 24.92 per cent return in 2020, more than doubling the since-inception performance of other sustainable ETFs like VESG or ESGI. Tesla returned 743.44 per cent in 2020.

Aussie sustainable funds side by side

*ETHI was founded 5 Jan 2017, 2017 returns are from this date.

Source: Morningstar Direct; accessed 6 May.

It’s a similar story among the holdings. Over the period since inception, the fund has had many more winners than losers. A total of 180 of ETHI’s holdings have had a positive return over the period since inception, compared to 12 losers.

Top 5 winners and losers (Inception to 30 March 2021)

Source: Morningstar Direct; accessed 6 May 2021

Aside from Tesla, the top four performers all provide technology and software for enterprises.

Annual expenses include a management fee of 0.49 per cent and fund expenses, capped at 0.10 per cent. ESGI charges 0.55 per cent, while VESG comes in at 0.18 per cent.

Growth funds carry risks

The fund’s returns look similar to growth and technology-focused ETFs such as Hyperion Global Growth Companies ETF (HYGG) or ETFS Morningstar Global Technology ETF (TECH).

ETHI alongside growth funds (Inception to 8 March 2021)

YTD figures are until 8 March 2021

Source: Morningstar Direct

A growth emphasis hurt many ESG indexes during the Q1 2020 rotation to value, because they tend to favour growth and technology over energy. The Russell 3000 growth index lost 5 per cent between 12 February and 4 March this year. The Nasdaq 100 lost 9.7 per cent over the same period.

While 180 of ETHI’s holdings have had a positive return over the 4½ years since inception, during the February-March decline, 141 of the holdings fell into negative territory. ETHI performed worse than blend funds like VESG or ESGI during this period, with a fall of -7.14 per cent, compared to -4.95 for VESG, and -3.82 for ESGI.

Globally, only 24 per cent of Morningstar’s ESG-screened indexes beat their broad market equivalents.

Performance of ETHI’s 200 holdings. Each line is one firm. (Inception and 12 Feb – 4 March 2021)

Source: Morningstar Direct

Sustainability in practice

ETHI scores highly on Morningstar sustainability scores with a 5-globe sustainability rating, putting it in the top 3 per cent of funds in its category. The rating indicates that, on average, more of its assets invested in companies that have lower ESG risk as characterised by Sustainalytics.

The fund also received a Morningstar “Low Carbon” designation, with no fossil fuel involvement.

Morningstar’s “ESG Commitment level” assesses a fund manager’s commitment to incorporating ESG principles into their investment organisation and process. The scale runs from Leader, Advanced, Basic, and Low.

BetaShares scores a Low because it does not impose any ESG principles, philosophies, or policies at the firm level or across most of its other product ranges.

ESG score breakdowns

Source Morningstar Direct and Sustainalytics

Tax evasion and animal testing

ETHI’s inclusion of pharmaceutical and medical research firms does expose it to animal testing. Sustainalytics, a Morningstar ESG research house, categorises animal testing according to whether it is used for pharmaceutical products, medical devices, biotechnology, or non-pharmaceutical products. Thirty-nine of ETHI’s holdings conduct at least one form of animal testing, with the majority doing so only for pharmaceutical purposes.

In relation to the claim that thirty-nine of ETHI’s holdings conduct animal testing, BetaShares says: “ETHI is one of the only sustainable investment funds to screen for animal testing, which is a key differentiator in the market. Companies which engage in animal testing for medical purposes are not screened from the fund.”

Companies accused of tax evasion have also found their way into the portfolio. ETHI holds a $7 million position (0.52 per cent) in Activision Blizzard, makers of the popular game World of Warcraft. The firm has a history of using tax havens in Bermuda and Barbados, according to NGO Taxwatch. In 2018, French tax authorities hit the firm with a €652 million bill. The company disputes the claims.

It’s a similar story for Netflix (NFLX), where ETHI has a $26.6 million or 1.96 per cent position. The Guardian reports the firm paid no income tax in 2018 and stands accused of funnelling profits through low tax jurisdictions such as the Netherlands.

When the fund was set up, exclusions based on tax minimisation were not common, says BetaShares' Gleeson. In 2019, 7 per cent of funds screened based on "paying a fair share of tax", according to the Responsible Investment Association Australasia.

"We spent a few years surveying the market to see what were considered important issues and the original screens were based on those," he says.

"The fact we haven't included it [tax minimisation] yet suggests it hasn't met the threshold."

Are you an avoider, engager, or changer?

There are three broad ways to invest sustainably: avoid, engage, or change. Avoiders want a good return but don’t want their money invested with companies who pollute, pump oil, or pay their workers a pittance—whether because of ethics or financial risk. Engagers are willing to invest in companies outside the ESG universe to create change from within. Changers only want to invest in businesses that directly contribute to a social or environmental aim.

ETHI performs admirably for avoiders and engagers, even if its inclusion of tax minimisers raises questions. Changers might prefer more thematic funds like BetaShares Climate Change Innovation ETF (ERTH) or VanEck Vectors Global Clean Energy ETF (CLNE).

This article appeared last week under the headline 'Under the hood of Australia’s largest sustainable ETF'. It has been updated with the following clarifications:

BetaShares wishes to state that “ETHI is designed to act as a diversified core portfolio holding of liquid, global companies, which focusses on climate leadership across industries and screens across a wide range of ESG issues."

A 'Year to Date' column has been added to the chart: 'ETHI alongside growth funds' alongside a sentence about this performance.