ESG ETFs, an insurer's tool for short and long-term risk management

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Charles Moussier, Head of EMEA Insurance Investment Solutions at Invesco

ETFs (Exchange Traded Funds) are emerging as a key vehicle for institutional investors to integrate environmental, social and governance (ESG) criteria into their portfolios. For insurers, especially, ESG ETFs enable the combination of strict compliance with regulatory requirements, flexibility in their asset allocation and the fine-tuning of their ESG strategy, including the implementation of self-indexing mechanisms.

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Strategies integrating ESG criteria have become core for investors. This global evolution of the asset management industry is especially obvious in ETF markets where the volume of assets adopting ESG management criteria has risen sharply in recent years.

According to data from Bloomberg¹ ESG funds are over-represented in European ETF inflows and have been gaining market share thanks to positive flows every month since January 2017. ESG products accounted for more than 12.6% of net inflows in 2019 and now represent 60.7% of ETF inflows in Europe since the beginning of the year. Out of a total net inflow of $USD 14.4 billion (€ 13,2 billion), $USD 8.7 billion (€ 8 billion) was raised by ESG ETFs.

Major institutional investors – among which insurers – have already switched their entire ETF portfolios to ESG. And far from being a stopgap, the Covid-19 crisis and the market volatility it brought seems only to have accentuated the trend towards ESG ETFs.

There are fundamental structural reasons for the growing attractiveness of ESG ETFs to insurers. The first relates to regulatory aspects: European insurers have to integrate ESG criteria into an increasing part of their asset allocation and investment strategies, with precise reporting requirements.

In France, Article 173 of the Energy Transition Act of 17 August 2015 requires institutional investors to disclose the integration of ESG criteria into their investments as transparently as possible.

At the European level, the new ESG reporting framework (Sustainable Finance Disclosure Regulation) will come into force on March 10, 2021. For insurers based in the European Union, this will mean, among other things, the obligation to publish on their website a detailed ESG risk integration policy.

Life insurers and all companies offering insurance-based investment products will also be required to inform clients in pre-contractual documents on how ESG risks have been taken into account, and their impact on value and performance.

Insurers with more than 500 employees will furthermore be required to disclose their policies concerning the negative ESG impacts of their investments. These same insurers are also subject to the Non-Financial Reporting Directive, with the obligation to disclose in the near future the percentage of investments financing green activities as defined by the EU Taxonomy, which defines sectors generating positive environmental impact.

Today, the regulatory framework set up to tackle climate change is very well assimilated by institutional investors. Many insurers have gone even further than regulatory requirements in integrating the ESG dimension. In our view, adopting ESG is no longer seen by insurers as a constraint, but as an opportunity.

In recent years, ESG strategies have indeed demonstrated their ability to reduce risk in turbulent markets, a principal objective for insurers. The ESG approach can gradually diminish risks over the long-term by lowering risks in the fields of fraud, climate, pandemic, etc.

This ability to outperform in difficult contexts was recently highlighted by Morningstar², which showed how sustainable ETFs had been more resilient than traditional ETFs in the first quarter, with 24 out of 26 ESG ETFs outperforming their non-ESG peers.

While this is partly due to lower exposure to the energy sector, resilience is ultimately a fundamental quality of these ESG funds, thanks, often, to crisis-resistant sectoral allocation strategies. By its very nature, this investment philosophy will avoid oil and favour healthcare, for example. This characteristic provides insurers with a natural ally in their especially prudent approach to risk management.

Another structural reason for the success of ESG ETFs with insurers is linked to the intrinsic qualities of ETFs in terms of transparency, flexibility, and cost. The first advantage for investors is that ETFs are transparent products that are easy to understand and invest in. Their ease of use is an asset for insurers willing to try new or complementary strategies, while increasing liquidity.

Second advantage: ETFs are flexible and liquid products. As we have seen through this crisis, ETFs have continued trading and offered liquidity - in both primary and secondary markets - under the most difficult conditions that investors have ever experienced. For many investors, the flexibility of ETFs and the ability to trade them at any time of day under conditions of extreme volatility seems to have made them even more attractive.

Third benefit of ETFs: they offer a low-cost structure for policyholders - a significant argument for insurers and all investors alike - allowing them to easily add an ESG advisory layer to their asset allocation. A strong advantage in a crisis environment where all economic actors are particularly cost-conscious.

In conclusion, the ETF format is especially well suited for advances in defining and implementing ESG strategies which are well aligned with the specific needs of each insurer. This is what we call "self-indexation". The aim being to create an index that complies with the ESG rules and strategies specific to each institution, since ESG approaches differ in the absence of a market standard.

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Warning

Investment strategies involve many risks. Investors in Invesco's products should be aware that the value of their investments can go down as well as up. It is therefore possible that you may recover less than the capital originally invested.

Important information

This document contains information provided for illustrative purposes only. It is reserved exclusively for professional investors in UK.

Where a management professional or an investment firm has expressed its views, these are based on current market conditions; they may differ from those of other investment firms and are subject to change without notice.

¹ as of 15/05/2020

² https://www.morningstar.com/articles/976361/sustainable-funds-weather-the-first-quarter-better-than-conventional-funds