The popularity of passive environmental, social and corporate governance (ESG) funds and thematic ETFs has led to huge to inflows that could be breeding a bubble where ultimately the cost of a burst will be borne by unsuspecting buyers, investment managers have warned.
Socially responsible investing and funds that emphasize ESG decision-making into their investments have been growing rapidly.
According to a report by TrackInsight, ESG ETFs saw their assets triple during 2020 alone. Last month witnessed flows of $19bn, pushing total assets to a new high of $210bn - the largest single-month in the history of ESG ETF flows.
ESG ETFs are a form of a thematic ETF, which simply put is meant to tap into a specific theme. These passive vehicles aim to buy stocks that benefit from their chosen theme and often charge higher fees than typical passive ETFs. Fees range between 0.4 and 0.6 per cent for the former versus 0.01 per cent for the latter.
However, despite the lack of standardised ESG reporting rules for funds and companies, the fund management’s industry-wide push to capture inflows of ESG-hungry investors isn’t stopping.
Tariq Fancy (pictured), former chief investment officer for sustainable investing at BlackRock, last week called out the industry’s deceitfulness in an article for USA Today. 
“In truth, sustainable investing boils down to little more than marketing hype, PR spin and disingenuous promises from the investment community,” he said.
“Existing mutual funds are cynically rebranded as ‘green’ — with no discernible change to the fund itself or its underlying strategies — simply for the sake of appearances and marketing purposes.”
However, the issue could be spreading beyond just questionable marketing practices. Richard Penny, manager of the CRUX UK Special Situations fund, is worried there could be a moral hazard brewing with some thematic ETF providers.
“You have to ask with the thematic funds, what happens if your opportunity set is very early-stage businesses or the valuations are too high?” he said.
“Do you turn around to investors and say, actually, everything's too expensive, or do you just keep buying them? I think we are seeing that with some of the thematic ETFs in the US.”
Thematic ETFs managers don’t need to worry about the prices of the underlying companies within their basket because they are considered passive managers.
They have every incentive to continue to accumulate assets and to take the risks of buying, because ultimately, they do not bear the risks if the companies turn out to be overvalued. This could pose a moral hazard.
“The issue with it is that when somebody is buying into robotics or artificial intelligence, they are buying into the idea,” Penny said. “But for an investment to be valid, it has to be attractively priced, and in a lot of cases I think some of these situations are overpriced and that's how a bubble can happen.”
He pointed to the valuations of stocks associated with popular themes such as gene editing or green energy in the UK, compared to those in the US. He has seen similar companies in the US market trade between five or 10 times higher than in the UK.
Many green ETFs benchmark against the Nasdaq Clean Edge Green Energy index, which tracks the performance of companies involved in clean-energy technologies.
Performance of the index over 1yr
Source: FE Analytics
Christopher Rossbach, manager the J. Stern & Co. World Stars Global Equity fund, said this is not an old problem for the investment management industry.
“If you have very good ideas but very limited opportunity sets, then you can have this issue where you have more money looking to invest than where there are opportunities - and you can get mispricing,” he explained.
He believes it is important to distinguish between companies that are becoming more sustainable in their business practices or their impact on the UN Sustainable Development Goals, versus what is defined by emerging regulations around sustainable investing.
For example, as part of the European Green Deal, regulators have created an EU taxonomy classification system that sets out a list of environmentally sustainable economic activities that investors must comply with if they wish to deem an investment ‘green’. These regulations can often dictate where the huge ESG ETF flows go.
“An example of how small the universe of companies that fulfil the criteria required by most sustainable ETFs is that only 20 per cent of the revenues of the Euro Stoxx 50 index are based on EU taxonomy relevant activities, and 2 per cent on EU taxonomy aligned activities,” Rossbach said.
This is according to a European Sustainable Finance Survey commissioned by the German Government.
This suggests that, at least in the EU, there could be a lot more capital chasing relatively few revenues that are classified as ‘green’ under these new regulations.
Rossbach (pictured) continued: “If investors just follow this drive to invest in businesses because they’re directly involved in sustainable activities, then they are taking on a function that they’re only indirectly supposed to have. 
“Markets are supposed to provide capital for innovation and companies that will generate return. If that function is taken over by indices and ETFs, then capital is provided to those companies in almost indiscriminate amounts and therefore divorced from the question of whether they will generate a return.
“To the extent you are forced to invest in them, you will drive up valuations because it’s a supply and demand issue.”
He believes there is a significant moral hazard because it directly undermines the function of what investment should do.
“People investing in ETFs need to be very careful about the underlying exposure they have, because they really do have the risk that they are buying a very limited set of companies, with very uncertain outlooks, at very uncertain valuations because they are following this specific approach,” he finished.
Yet despite the huge increase in ESG inflows seen recently, investor appetite for thematic ETFs more broadly doesn’t appear to be slowing down anytime soon.
According to a global ETF survey conducted by Brown Brothers Harriman, around 80 per cent of global investors plan to increase their allocation to thematic ETFs in 2021.
Source: Brown Brothers Harriman
Roughly two-thirds of global asset allocators surveyed expect between 11-20 per cent of their portfolios will be in thematic ETFs within the next five years.
Thematic ETFs can cover other themes such as robotics, healthcare or even cannabis. Indeed, cannabis ETFs are amongst the top-10 performing type of funds so far this year, off the back of the expectation that the US will pass federal legalisation across the country.
Whether the prices of green energy or marijuana stocks are fundamentally sound remains to be seen. Yet it appears it won’t stop investors from buying passive vehicles that buy into companies without regard for their price.
Calastone - a global funds transaction network – recently revealed that within their network, ESG funds have taken $84 out of every net $100 flowing into equity funds during the last two years, a total of $15.1bn out of $18.1bn.
One must wonder how many ESG ETFs will be stuck holding electric vehicle firms such as Nikola Motors and Lordstown Motors, which have both been plagued with lawsuits accusing them of defrauding investors.