While ETFs focused on companies helping protect the environment or practicing good corporate governance remain a small piece of the growing ETF pie, they are starting to capture larger slices, explains Todd Rosenbluth, analyst with CFRA Research in The Outlook.

Assets in environmental, social and governance (ESG) equity ETFs climbed 63% since end of 2017, stronger than 17% growth for broader smart beta ETF strategies as of late May.

In 2019, some highly successful ESG product launches helped to drive overall flows; however, we think many investors do not understand what drives, and what does and does not make it into an ESG ETF.

As of late May, $8.5 billion was invested in ESG ETFs, $2 billion more than at year-end. This was largely driven by the successful launches of Xtrackers MSCI USA ESG Leaders Equity (USSG) in March and iShares ESG MSCI Leaders (SUSL) in May.

Aided by investments from a European insurance company, the two ETFs pulled in $2.3 billion within the first three months of trading. They joined iShares MSCI KLD 400 Social (DSI 103 Overweight) and iShares MSCI USA ESG Select (SUSA 114 Overweight) in the $1 billion assets under management club.

Unlike smart beta ETFs that screen in securities based on fundamental and/or performance-based attributes, these $1 billion ESG ETFs focus more on excluding stocks that do not score well based on ESG criteria.

Under the three ESG pillars (Environment, Social and Governance), MSCI breaks down companies based on 10 themes. For environmental, these are climate change, environmental opportunities, natural resources and pollution waste.

For social, these are human capital, product liability, social opportunities and stakeholder opposition. Lastly for governance, these are corporate behavior and corporate governance.

However, some of the recent demand for these ETFs has been offset by outflows from others. For example, iShares MSCI ACWI Low Carbon Target (CRBN) and SPDR SSGA Gender Diversity (SHE) had approximately $430 million and $270 million in assets, down from $540 million and $360 million at the mid-point of 2018.

These two ETFs focus on just one of the three ESG pillars — CRBN on Environment and SHE on Governance — rather than covering all three. They both earn our "overweight" rating.

According to Thomson Reuters Lipper as of  May 29, the largest ESG exchange-traded funds are:

iShares MSCI KLD 400 Social (DSI)
Xtrackers MSCI USA ESG Leaders Equity (USSG)
iShares ESG MSCI USA Leaders (SUSL)
iShares MSCI USA ESG Select (SUSA)
iShares ESG MSCI EAFE (ESGD)
iShares ESG MSCI EM (ESGE)
iShares MSCI ACWI Low Carbon Target (CRBN)
Vanguard ESG US Stock (ESGV)
SPDR S&P 500 Fossil Fuel Reserves Free (SPYX)
Invesco Solar (TAN)

Historically, ESG ETFs had been priced at a premium fee to market-cap weighted and smart-beta ETFs. However, asset managers have brought the same level of competition to this potentially up-and-coming investment approach as they have others.

Xtrackers MSCI USA ESG Leaders Equity charges a miniscule 0.10% expense ratio and all but one of the top-10 largest ESG ETFs has a 0.25% expense ratio or less.

In addition, investors that prefer an ESG approach can build a global portfolio. iShares also offers popular developed and emerging markets focused ETFs through iShares ESG MSCI EAFE and iShares ESG MSCI EM, while Vanguard and DWS offer competitors.

We think ESG investors will continue to gain comfort in using ETFs to gain exposure to these approaches in the coming years.

Subscribe to CFRA Research's The Outlook here…