ESG ETFs and the Costs of Information Synthesis

By | October 4, 2021

            Despite likely being the most successful investment product since the 2008 global financial crisis, exchange traded funds (ETFs) have a serious comparability problem. The problem is particularly acute in environmental, social, and governance (ESG) themed funds, which have benefited from a recent surge in investor interest. A post-crisis explosion in ETF product offerings, combined with extensive issuer discretion in the composition, replication and tracking of underlying indices and in operational, financial, management, naming and marketing practices has undermined the ability of investors to perform accurate side-by-side product comparisons without relying on expensive intermediated aggregation services.

The net result of this product choice expansion and issuer discretion is a tremendous informational synthesis burden on investors, and the potential for significant capital and risk misallocation. In fact, the information synthesis costs for investors to accurately compare ESG ETFs side-by-side are so significant, that in a new article, I argue that “comparability” in ESG ETFs is actually a much greater problem than so-called “greenwashing.” As the number of available ETFs continues to expand, and the scope and operation of available products like thematic and ESG funds across the ETF universe increases in complexity and subjectivity, regulatory frameworks must adjust for the costs of information synthesis.

To protect investors and ensure efficient capital allocation, modern financial markets need more than just information disclosure and registration. Regulators must increasingly look to enhanced standardization rules, centralized aggregation services, and marketing and layout consistency measures to lower the costs of information synthesis so that investors can accurately compare products side-by-side. As I argue in my article, investors in ESG-themed ETFs would face lower information synthesis costs if ETF issuers had to justify their use of ESG terms in disclosures, ESG terminology and measurement metrics were standardized, and there was a consistent layout format for the presentation of ESG-related information on websites of ETF issuers.

Investor Protection and the Costs of ESG Information Synthesis

The ETF industry is evolving in a way that is levying tremendous information synthesis costs on investors. Growth in the ETF market—in terms of the number of available products as well as the complexity and discretion in their formation and operation—is unidirectional. There are no signs that the market is moving to completion. In fact, watching the ETF market evolve and complexify gives support to prior scholarship that suggests that financial innovation is largely “supply side,” and driven by the profit-seeking activities and marketing of financial intermediaries like asset managers. The costs of comparative synthesis have a disproportionate impact on retail ETF investors who face a nearly impossible task of performing an accurate “apples to apples” assessment for ETFs. It also creates financial inclusion barriers since sophisticated—and costly—aggregation and analysis services are now needed for retail investors to truly perform a side-by-side comparison of the subtle nuances in ETF composition, operation, and risk.

In prior scholarship, I’ve illustrated the many challenges in ETF comparative complexity and product choice “overload,” and how issuer discretion exposes investors to potential harm, risk and capital misallocation, and capital-flow advantages for large ETF mega-issuers. The ESG product sub-segment introduces numerous comparative pathologies, some of which are unique to ESG, and drives the need for heightened regulatory attention on information synthesis costs. This is particularly needed given the strong recent investor interest in ESG.

Greenwashing is a Media Distraction—the Real Concern is Comparability 

In the articleI build on my prior work and illustrate the acute problem of comparative complexity and information synthesis costs in ETFs by focusing on the very popular ESG-themed ETF product sub-segment. Here, I survey the investigative studies on ESG integration in ETFs to show that there is very little evidence of pervasive “greenwashing” in this product sector.

“Greenwashing” is a term that is commonly used to describe deceptive behavior of firms or asset managers who publicly signal intent to incorporate sustainable practices or decision making factors into their operations, or investment inclusionary decisions, but fail to follow through on such measures. You would think that ESG investing is nearly synonymous with “greenwashing,” given the extensive coverage of this term in the financial media. However, studiessuggest the opposite—that investment funds, including ETFs, are actually integrating ESG considerations into their investment inclusionary decisions.

The media’s fixation with greenwashing is an unhelpful headline-grabbing distraction, since ESG integration in investment products is not a binary proposition. It is the nature of ESG integration that is most important, and when you dive into the fast-exploding world of ESG ETFs, it becomes clear that these products are very difficult to compare side-by-side given the non-standardized use of ESG terminology, the subjectivity that ETF issuers use to integrate ESG considerations, and the ever-expanding availability of diverse ESG measurement metrics and scoring methodologies that influence underlying basket inclusionary decisions. As I investigate in my article, ETF issuers also have incentives to avoid greenwashing, given the hyper-competitive, hyper-liquid, and fee-sensitive ETF ecosystem.

            Greenwashing narratives reduce the idea of ESG investing to a binary proposition. However, as I argue, in comparing ESG ETFs side-by-side, the “details are important.” To accurately compare ESG-themed ETFs, an investor must perform a costly side-by-side analysis of “how” ESG considerations are integrated into a respective fund, and what specific measurement or scoring metrics are utilized. The latter point usually requires second-order comparative analysis of diverse ESG commercial providers and rating services with widely disparate quantitative assessment measures. Additional third-order information synthesis efforts are needed to do a fund-by-fund comparison of how “E,” “S,” and “G” considerations are individually integrated and distinguished. This analysis is obfuscated when underlying holdings include certain technology stocks that may score highly in the “E” element of sustainable investing, but low in “S” or “G.”

            There are many elements of an ETF which are important, but difficult to individually assess—like, among others, whether (and why) there is potential instability in the arbitrage function, whether a fund has a greater propensity for tracking error relative to its peers, the extent a fund engages in securities lending, or the way that its underlying net asset value is calculated. We can now add “how” ESG is integrated into a fund to that growing list. Studies in behavioral finance show that decision making is enhanced when “hard to evaluate” attributes of products are presented in comparative formats. Unfortunately, the largest ETF issuers have incentives to maintain the opaque status quo, given another behavioral principle called “overreliance on salience.” This occurs when investors mistakenly believe that larger (and higher profile) firms have better products. An ESG ETF investor—overwhelmed by information synthesis costs when comparing products—may easily default to BlackRock, for example, which is not only the largest asset manager in the world, but also likely the most aggressive in advancing ESG investing.

Where Adjustments Are Needed to Improve Comparability in ETFs

Given trends of even more ETF product choice and complexity in the future, paved by regulatory accommodations easing the path to launch for new ETF products and “semi-transparent” and actively managed ETF structures, there is a critical need for regulatory adjustments to aid investor comparative efforts and lower the costs of information acquisition and synthesis. There is more to investor protection than information production. Investors must be able to synthesize the available information in an accurate way that allows them to make rational investment decisions in accordance with their risk preferences. This leads to efficient capital formation and risk allocation. The current state of the ETF industry, however, undermines this ability, and levies tremendous information synthesis costs on investors, with a disproportionate impact on those who can’t access aggregation services.

I’ve previously advocated for ways to mitigate the negative externalities of ETF product choice overload and comparative complexities. For example, by instituting ETF standardized naming conventions and terminology, comparative synthesis is improved. Further, a centralized data repository, where investors can compare fund-level data side-by-side, lowers information synthesis costs, and allows easier comparative assessments without also having to navigate potentially dozens of issuer websites for a single fund-level analysis or needing costly aggregation software. Also, consistent information presentation formats (specifically in the layout and presentation style of ETF issuer’s websites) aids side-by side comparisons. For ESG-thematic ETFs, regulatory adjustments to lower information synthesis costs would include standardization efforts in ESG terminology and measurement metrics, uniform disclosures justifying terminology usage, and enhanced consistency in “how” (including website format) ESG information is presented to investors.

Dr. Ryan Clements is an Assistant Professor, Chair in Business Law and Regulation, at the University of Calgary Faculty of Law and a Nonresident Fellow of the Duke Global Financial Markets Center.

This post is adapted from the author’s forthcoming article, “Why Comparability is a Greater Problem Than Greenwashing in ESG ETFs” available on SSRN.

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