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By supporting investment in areas such as healthcare, technology and clean energy, a growing number of exchange traded funds promote themselves as delivering rewards to both society and investors.

But the chequered recent performance of many thematic funds has provoked a reappraisal of investor commitment to this expanding investment space.

Many funds boasting environmental, social and corporate governance (ESG) credentials, and other fashionable “future economy” themes, performed well during the earlier days of the Covid pandemic, attracting strong support from investors.

But a lot of these portfolios have since performed poorly — leaving many ESG and thematic names especially vulnerable to the recent sell-off.

Inflows into both ESG and thematic ETFs have slowed markedly this year in the European market and, in the US, in many instances, they have gone into reverse.

Column chart of Net flows into European thematic ETFs (€bn) showing Rise and fall

However, in spite of this slowdown, thematic funds continue to take on money and product providers have continued to launch new versions, even in the wake of market volatility. In September, fund giant Fidelity entered Europe’s thematic ETF space for the first time and several other providers unveiled new products. Three such funds focused on the metaverse — backing the commercialisation of shared virtual environments on the internet — suggesting some faith among ETF suppliers and clients that hot tech trends will prove profitable.

Invesco also launched some additional wind energy and hydrogen economy ETFs last month, to add to its portfolio of green energy funds — suggesting environment and other ESG-themed products remain in demand.

From clean energy funds such as iShares Global Clean Energy ETF to gender equality funds such as Lyxor Global Gender Equality UCITS ETF, many of the new thematic portfolios can be viewed as increasingly specialised ESG investments — matching a trend towards a greater granularity in fund offerings, as seen in other thematic segments.

Technology had been the dominant Morningstar subcategory in the thematics space. But the “physical world” category — covering the management of resources and the shift to clean energy — has expanded its presence over time.

Specialists now predict the arrival of more such granular plays, cementing the overlap between thematics and ESG.

Goncalo Machado, a manager at ETF investment platform InvestEngine, adds: “I am seeing big products, like the MSCI World ESG trackers and the like, being slowly phased out into more thematic ETFs such as carbon offsetting/decarbonisation and future of food [funds].”

At the same time, there are question marks over the broader ESG funds that Machado sees being displaced. These ESG takes on well-known equity indices, such as the S&P 500 — especially those with a “light” touch approach that excludes only the most controversial companies — can, at times, stand accused of ‘greenwashing’.

But not all anticipate the “ESG-lite”, broad-brush funds fading away. This is because many investors do not wish not to stray too far from conventional index-tracking funds and miss out on potential gains. As Peter Sleep, senior portfolio manager at 7IM, puts it: “A lot of fund managers want to ‘green’ their portfolios without giving up anything on performance”.

But fund providers face more pressure to show that they are diligently applying ESG criteria to portfolios labelled as such. Europe’s recently introduced Sustainable Finance Disclosure Regulation requires funds to categorise themselves according to how committed they are to sustainable investing.

Other watchdogs are also getting in on the act. In September, the UK’s Financial Conduct Authority called for better scrutiny of whether investment products meet their sustainability claims. “We believe that the subjective nature of ESG factors, and how ESG data and ratings are incorporated into benchmark methodologies, give rise to an increased risk of poor disclosures in ESG benchmark statements,” said Edwin Schooling Latter, the FCA’s director of infrastructure and exchanges.

The US Securities and Exchanges Commission, too, is proposing tougher disclosure requirements for ESG funds.

In addition, advocates of sustainable investment funds in some US states are having to contend with pressure from the other side of the fence. Last year, Texas passed a law attacking ESG investing that requires state funds to divest from financial groups that “boycott energy companies”.

Florida has also passed a resolution banning its pension fund managers from taking ESG considerations into account with their investing strategies.

One way or the other, ESG fund providers are increasingly being drawn into the political arena and being asked to up their game. With pressure to demonstrate meaningful ESG credentials or step back, fund providers will at least have to get off the fence.

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