Managers of ETF funds are tightening up their screening on ETF products, thanks to demand from big institutional investors like pension funds.
Leading ETF provider WisdomTree reported this week that is was toughening up the screening criteria for its self-indexed ETFs that include its developed equity markets and thematic ETF strategies.
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What this means is that WisdomTree will be excluding more companies including areas like small arms makers, oil sands companies, and companies involved in Arctic oil and gas exploration. The changes will affect 17 ETFs in WisdomTree’s range of listed fund products.
The new areas of exclusion will cap revenue generation thresholds at 5%, so it would be possible for a company which only derives a small part of its revenue within these areas to still be included. Restrictions are also being tightened on companies that receive revenue from tobacco and also thermal coal. These are all being cut to 5% maximum revenue, WisdomTree said this week.
The moves from WisdomTree are part of a wider move within the ETF industry to embrace stricter ESG criteria for the booming asset management sector. Index provider MSCI has made a number of changes to its screening criteria in the wake of consultation with the market, prompted in part by tighter ESG requirements within the European market.
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Wide ranging reforms by index providers
This has caused some other fund managers to have to make changes to their existing ETF ranges. MSCI said effective 1 March it was bringing in a carbon intensity reduction of 30% compared to the parent index. The ESG indices its provides will exclude companies that derive more than 5% of revenue from the production and distribution of palm oil or the extraction of oil and gas in the Arctic.
Other companies that will be hit are those with an ESG controversy score.
MSCI said fund managers and other market participants had recognised the need to respond to the European Union’s Sustainable Finance Disclosure Regulation (SFDR) as well as the Markets in Financial Instruments Directive (MiFID II) which includes sustainability preferences. Currently these European regulations are in a state of flux and both index data providers and ETF managers are cautious about implementing stringent reforms to products that might need to be dialled back.
MSCI argued that making too many changes risked disrupting the performance of some very large ETF products – e.g. by increasing tracking error or rebalance turnover. It could also require changes to the way market capitalisation weighting is organised.
Big fund managers are responding to EU regulations
Among the other fund managers making changes are BlackRock and Invesco. In the case of Invesco, its own independent index provider Solactive changed its index calculation methodology in order to comply with SFDR.
The changes will also hit companies that are not providing enough data to index companies used by ETF managers. If it is not possible to calculate a company’s controversy score, for example, that company risks being excluded altogether, potentially with ramifications to its share price.
It is also very challenging for fund managers to meet the so-called ‘dark green’ top grade ESG classification methodology, also known as Article 9 under SFDR. This led BlackRock, for example, to downgrade its Article 9 Paris-Aligned Benchmark and Climate Transition Benchmark ETF range to Article 8, which is one step down in the methodology.