Introducing The Latest ESG Headache: The $15 Billion Swap-Based ETF

One of the world's largest synthetic exchange-traded funds is beginning to resemble exhibit A in the recent ESG rating debate.

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Invesco Ltd. manages the $15 billion ETF, which employs swaps to provide clients with exposure to the S&P 500. MSCI ESG Research, the largest issuer of such ratings, presently assigns the ETF an AA grade. Yet, according to European Union regulations, the fund is classified as Article 6, which means it does not have any environmental, social, or governance purposes.

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The lack of agreement in ESG categories demonstrates the difficulties investors confront when attempting to allocate funds. Though Invesco has not registered its synthetic ETF as an ESG product, the fund is already included in at least three other portfolios in Europe that claim to "support" ESG, according to Trade Algo.

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In light of this, MSCI said on March 29 that it intends to significantly reduce the number of funds to which it provides top ratings. Feedback from MSCI's clients, notably Invesco, prompted the assessment. Among all public fund categories, 31,000 are now facing ESG rating downgrades, with the share of AAA funds likely to fall from around 20% to 0.2%. AA funds will shrink from 33% to around 22% of the universe.

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MSCI is revising its methodology for swap-based ETFs such as the Invesco fund, moving away from scores that reflected the features of a synthetic fund's collateral and instead looking at the members of the underlying index being tracked. While MSCI has said that there would be fewer top-rated funds, it has not stated how specific products will be affected.

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It's the latest difficulty to hit the ESG investing market, as existing classification methods are under scrutiny. In Europe, the fund sector concluded 2022 by removing the highest ESG label off €175 billion ($190 billion) in client assets, with experts forecasting that more will follow. The turmoil has prompted the EU to reassess its ESG investment guidelines and to investigate dramatic changes to funding labeling.

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MSCI's existing approach, according to Chris Mellor, head of EMEA ETF equities product management at Invesco, gauges something that "has no real significance for the performance of the ETF," and he expects the proposed revisions to increase the dependability of MSCI rankings.

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Mellor believes that assigning ESG ratings to swap-based ETFs makes sense if the approach is reliable.

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"If you think about what the ESG grade tells an investor, it tells them what the dangers are to that investment from an ESG standpoint," he explained. "This will have the same effect on the performance of a synthetic ETF as it would on the performance of a physically replicated strategy." As a result, it is equally applicable to a synthetic fund as it is to a real fund."

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The offering from Invesco is far from unique. According to statistics, nine of the top ten synthetic ETFs registered in Europe presently have MSCI ESG ratings of at least AA. At the same time, all are classified under Article 6, which means they do not promote themselves as ESG. According to MSCI, the revisions will go into effect at the end of April.

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MSCI has recommended that investors would be better served if rating models were diversified in response to a European Commission consultation on ESG ratings.

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"Today, the lack of consistency in ESG ratings is sometimes considered as a drawback; nonetheless, we feel it highlights the diversity of ideas and methodology." By contrast, there would be little usefulness if all financial counselors made identical buy/sell/hold decisions when evaluating equities. The diversity of perspectives and techniques reflects a dynamic and competitive market in which investors may choose between single suppliers who represent their perspective and several providers who supply various and diverse inputs. "A required one-size-fits-all approach to ESG ratings would diminish the ratings' thoroughness, originality, efficacy, and evolution," MSCI stated in June.

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The issuance of ESG ratings to synthetic ETFs is a contentious move in and of itself. Other ESG score providers have shied away from attempting to analyze the sustainability of derivative-based goods.

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Sustainalytics parent Morningstar Inc. concluded a few years ago that whether a rating system was based on collateral or underlying indices wasn't the problem, according to Hortense Bioy, the firm's worldwide director for sustainability research.

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"Both choices were flawed and had the potential to mislead investors," she explained. "As a result, we do not provide ESG ratings to synthetic ETFs."

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Another rival to MSCI, ISS ESG, stated that few swap-based ETFs will be evaluated using its approach.

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"To the degree that we cover synthetic ETFs, we do so based on the actual holdings, not the index they are tracking," said Till Jung, managing director, and worldwide head of ESG products at Institutional Shareholder Services' sustainable investment arm.

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According to Bloomberg statistics, Invesco provides 62 synthetic ETFs with more than $30 billion in client assets, but just one is marketed as having any ESG qualities.

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"The strategy we use is to ensure that the collateral basket constraints are linked with the index's restrictions," Mellor explained. "We also impose certain extra limits based on ESG score, for example."

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According to statistics, Amundi SA, whose owner Credit Agricole SA is the largest supplier of swap-based ETFs in Europe with well over $70 billion in client assets, advises clients not to rely on a single ESG rating source when selecting how to deploy their money.

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"Third-party fund ratings let investors evaluate various products using the same techniques," said an Amundi representative, but "changes like these demonstrate the risks that dependence on one data source may bring." "Amundi collaborates with many data suppliers and employs its scoring system and due diligence to analyze the ESG qualities of issuers and funds."

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