Roundtables & Panels

Roundtable: Are thematic ETFs active?

ETF Roundtable Collage
Company engagement and good returns go “hand in hand”, says an expert on our panel, as we discuss active exchange-traded funds and the role of ETFs in the green transition.

Gilles Dubos, ETF expert, Caceis
Marie Dzanis, Head of Northern Trust Asset Management Emea, Northern Trust FlexShares 
Stuart Forbes, Co-founder, Rize ETF 
David Hsu, Senior investment product specialist, Vanguard 
Tony O’Brien, Chief commercial officer and head of ETF Europe, U.S. Bank 

Funds Europe – Would investors be right to view thematic ETFs as a form of active management?

Stuart Forbes, Rize ETF – An ETF is just a wrapper for an underlying investment strategy, in the same way that a mutual fund is, too. It’s just that ETFs are associated by many people with cheap, transparent, passive products historically because those are the strategies that were typically put into ETF format. 

In reality, there’s a sliding scale for an ETF or a mutual fund to be considered ‘active’. There are very active strategies where there’s a higher level of discretionary intervention in the portfolio over time; and you’ve got others that are so-called ‘active’ strategies but have far less discretionary intervention over time and, in some cases, are really just closet trackers.

Then there are rules-based index strategies that, depending on the complexity of the selection and weighting criteria. These can be considered as very passive or smart beta, which use purely rules-based, objective criteria to select and weigh constituents. 

Some index strategies permit some level of discretionary intervention, introducing elements of active, but that entirely depends on the governance structure and transparency of that intervention. All indices require a degree of research and information gathering to support the constituent selection process. 

With thematic indices, there will always be an element of research to support constituent selection and the weighting process, But again, the degree to which research is used will depend on the quality and complexity of the strategy and how much active intervention is proposed for the product over time. There is no set definition of active or passive, and accordingly, the focus should be on identifying what the investment strategy is and the governance around how it is managed. Thematic ETFs sit on a sliding scale of robustness and quality of supporting research and construction. 

David Hsu, Vanguard – Thematic ETFs are, first and foremost, thematic. It could be active but doesn’t have to be active, depending on whether it is tracking a thematic benchmark. In the end, it depends on what your views are on that theme. For us, it’s something that we don’t focus on at Vanguard because we focus a lot on the retail audience looking at a more broadly diversified investment style for long-term demand. 

Tony O’Brien, U.S. Bank – The first few ETFs launched in Europe way back in 2000 were all traditional passive products, but quite quickly after that, they adopted what we were calling at the time ‘sectoral ETFs’, which were absolutely thematic in nature. Thematic investment is not new.

Active management of an ETF can happen at two levels – an ETF can ‘passively’ track an index, but that index itself can be selected in an active way to track certain attributes of the underlying stocks. The early sectoral ETFs would be good examples of this.

“Engagement is a core tool that investors have in their toolbox. They can be an agent of change within companies by incorporating ESG investments in their portfolios.”

Is that active management? I think so. Of course, the ETF itself can also be managed in an active way with little to no passive index tracking – we are seeing more and more of this coming to us.

There are also actively managed products that are transparent and could be considered thematic. In fact, the first ETF we’re launching in Europe with one of our clients is a thematic fund focused on stocks that are likely to benefit from a more inflationary environment. It’s active in that they make decisions about what they invest in but are purely transparent in that they do not feel a need to hide their strategy from the market. They’re very open about the methodology.

Marie E Dzanis, Northern Trust – I’m thinking about the topic of capitalising on long-term trends. Instead of a more traditional way of thinking of companies and sector criteria, what emerges is something that could enable an entire shift in the industry and focus. A great example of that is ESG thematic investing. There are specific solutions that allow investors to access a highly liquid transparent formula in a modular way in their portfolio. Certainly, there’s a desire for investment managers to create products like that to enable investors to do so.

What’s unique and distinct, though, concerning ETF capability is that it might be actively designed and passively managed if it’s following an index. It enables the investor or the investment manager to have dispassionate implementation of the security itself.

Gilles Dubos, Caceis – We believe there are three approaches. First, a passive product will follow a well-established index with little intervention. Secondly, a fund issuer might create an index where there is a lot of work being done at the initial stage of project creation, the companies that are targeted and the logic going to be applied to that index calculation. That approach has, in effect, some level of active management in the conceptualisation of the product.

Thirdly, there is the pure active approach, which doesn’t follow an index, but simply has an investment theme and will be active in its management on a day-to-day basis. 

We can also differentiate the bond products approach that follows an index but more from a sample point of view where there will also be a certain level of active management.

Funds Europe – Suppose investors increasingly pursue environmental-led investing objectives through ETFs. Does this compel providers of ESG-linked ETFs to pursue shareholder engagement strategies to steward companies from ‘brown’ to ‘green’ in the carbon transition? Is there a risk of greenwashing if they don’t?

Dzanis – As an investment manager, we have an entire spectrum of clients from ‘brown’ to ‘green’ globally that are looking to either have the purest strategies that would be with forest green investments, or at the other end of the spectrum, those wanting to invest their money in companies that can have the wherewithal to affect change. 

Looking at the ETF and the broader financial products landscape, we’ve seen a considerable surge of environmental solutions since about the end of 2019, driven by the regulatory environment. We saw this with the Sustainable Finance Disclosure Regulation (SFDR) and the benchmark regulation in Europe and also globally. And we saw this also with the appearance of more reliable data. 

More investors are thinking about environmental adjectives. They want to have exposure in their portfolio across the entire portfolio. Equity, bond and cash would reflect their values, and part of the ESG approach is to have ETFs nested in the portfolio construction, giving them choices of what they want to be exposed to and to what extent.

Engagement is another core tool that investors have in their toolbox. They can be an agent of change within companies by incorporating ESG investments in their portfolios. Many environmental ETFs look to follow a pathway on energy transition. That requires corporations to change their strategies and be provided with the tools to do so.

O’Brien – At the most basic level, the capital markets are a mechanism for the allocation of capital. Capital moves naturally towards favourable companies and away from unfavourable ones. With SFDR, we are seeing – really for the first time – an effort by regulators to modify that capital allocation in order to effect a societal good.

The point of SFDR is to encourage society at large, the investing public, to allocate capital towards environmentally friendly businesses and away from businesses that are damaging to the environment. ETFs play an important role here. 

ETFs are wrappers for strategies, and they facilitate that allocation of capital, one way or another. It doesn’t really matter what the underlying strategies are. ETFs, by providing an easy and transparent route for investors to obtain exposure, will reflect the demand from investors to whatever exposures they need.


The interesting point is that as ETFs become more and more prevalent as a route to market for investors, should issuers of ETFs encourage the underlying companies to improve their green credentials? As they own larger and larger proportions of those companies, should they exert an influence? That’s fundamentally a question for the issuers and investors to answer.

Dzanis – The EU recovery fund has two critical outcomes. One is the digitalisation of the EU, and the second is green recovery – and that focus and commitment go into each country. It has its own targets, and they’re evidence that they want to propagate good practice in business and fund companies and push monies towards these green outcomes. 

Dubos – Do we only judge the ESG fund based on the long-term impact that it might have, or do we also judge the return on investment and the value for money?

Providers of ESG-linked ETFs should pursue the objective of going towards darker green and – noticeably through votes on resolutions or corporate actions – choosing the option that is weighing strongly towards a greener choice but is also delivering good financial results. The two go hand in hand.

It is important to note the perception of ESG can be different from one investor to the other, for example, nuclear, gas or wind farms.

An interesting avenue emerging in the US is where the fund issuers are allowing underlying investors to participate directly in proxy voting. Putting aside the potential operational challenges, it could be an interesting approach to the topic.

Hsu – ESG definitions vary between investors. The world keeps changing, and this is a big part of the challenge. From our side, the stewardship department is separate from the ESG department, which is an important separation; otherwise, things can become cloudy. 

Many of our funds are exclusionary, predominantly in the FTSE Choice series. They’re part of the building blocks and are simple and transparent. Doing it this way simplifies things because ESG can be confusing, not just for investors but also for providers.

Last year, over 70% of the new ETF launches were all ESG-related. That’s high! Note that some of them have been converted from standard legacy products.

“Providers of ESG-linked ETFs should pursue the objective of going towards darker green and – noticeably through votes on resolutions or corporate actions – by choosing the option that is weighing strongly towards a greener choice, but is also delivering good financial results.”

Forbes – We have noted that international asset managers, particularly the largest ones, are really struggling to satisfy their conservative US clients on the one hand and, on the other hand, the more liberal European client base and the generation to whom wealth is transferring. 

The liberal European client base and younger generation strongly believe that asset managers have a stewardship responsibility over the assets that they manage and should be actively using that influence to compel their portfolio companies to improve their performance on environmental and social metrics and improve their governance structures to avoid future controversy. 

Conversely, the more conservative client base is demanding – and doing as much as they can to force – a pullback from that stewardship role, which they believe is not the purview of asset managers to fulfil. This is an increasingly publicised identity crisis for the largest asset managers and one that will be challenging for them to resolve under a single brand. Both ends of the client spectrum are telling them that “if you don’t do what we want, we will pull our assets”. We’ve already seen certain states in the US pull money from some of the largest managers.

The fact is that, if you are building products that purport to incorporate ESG and sustainability, stewardship – i.e. engagement and voting – is a critical component of that, one that cannot be abrogated. And investors who you have sold your ESG process to are increasingly demanding evidence of your process in action. What action have you taken, what companies have you screened out or not screened out and decided to engage with instead, and why? 

Many asset managers talk about the extensiveness of their engagement programmes but do not acknowledge how ineffective traditional engagement programmes have been. The world is hotter, less biodiverse and less safe than it was two, five and ten years ago. One of the realities is that a huge percentage of public companies, particularly smaller companies and companies based in jurisdictions where corporate governance requirements are less prominent, simply do not respond to engagement efforts, or at least not meaningfully. 

So, engagement can be more effective, but it will only get there if asset managers start working together on collective engagement initiatives that combine resources, homogenise the questioning and, therefore, make it far easier for companies to respond by creating a single point of engagement. If every asset manager sends their own bespoke 100-page questionnaire to every company, it means investor relations people at portfolio companies are completely overwhelmed and the companies are spending finite resources on hiring people to write responses to questionnaires rather than fix the issues and/or invest in adopting new initiatives within the company. 

Funds Europe – How significant is the recent clarification of EU regulatory guidelines, which led to several ETFs being re-categorised from Article 9 to Article 8 under SFDR regulations? Does this indicate a tightening of regulatory scrutiny?

Dubos – Going to the beginning of the SFDR regulation, there was a promise to promote ESG to establish a classification between the funds and their intentions. However, it’s been a victim of its own success, with several fund issuers creating products and launching funds with ESG and sustainability in their title, showing that it’s become a labelling exercise, and that’s been done alongside regulation that lacks clarity.

With the large number of ESG funds launched last year, there was some clarification in the second half of 2022. Unfortunately, there’s probably not all the clarity required, with fund issuers erring caution and downgrading their funds from Article 9 to Article 8.

There is also the topic of interpretation. Several Paris-aligned benchmark funds have been downgraded from Article 9 to 8. Not all of them, but a good few of them. And then recently an advisory to Esma [the European Securities and Markets Authority] considered that Paris Aligned Benchmark funds should be classified as Article 9. So, we’re still discerning that regulation and it’s driven by data with the EU taxonomy template and the European ESG template reporting, and it’s quite detailed and raises the question of data availability.

There is an important difference if you invest in European assets versus non-European assets. If the latter, access to the data is going to be key since the reliability of that data is going to be an issue. 

Dzanis – Data is an important aspect of it, and the governance and the framework you’ll have around this process are vital because the volume of information we’re interpreting and putting into this framework is critical.

To your question, this is vital work, and I view it as part of an iterative process. Looking at our own firm, we’ve been working with sustainable investing for 30 years, but the first ten years were all about exclusion. The next ten years will centre on holistic solutions and targeting different outcomes. 

So, now we’re in a dynamic framework around how we’re providing next-level solutions. Part of that is framing the spirit of the regulation. This means the outcome we’re trying to get, with transparency and clarity, is that the end investor knows what they’re getting. The outcome the regulator wants is no harm to the investor, capital markets and firms.

And we need to step through this process together as an investment community, and you will see iterative changes. I anticipate that there will be even more changes as more information and data become available. 

Forbes – There was no meaningful ‘clarification’ that led to the re-categorisation of Article 9 ETFs. The only thing that Europe said was that they expect a majority of an Article 9 fund’s assets to be comprised of sustainable investments. We are still waiting for clarification from the European Commission on how you quantify ‘sustainable investment’. 

“A huge percentage of public companies, particularly smaller companies and companies based in jurisdictions where corporate governance requirements are less prominent, simply do not respond to engagement efforts, or at least not meaningfully.”

However, the definition of sustainable investment is – and it has been since the Level 1 regulation was adopted in March 2021 – comprised of three mandatory criteria, all three of which asset managers were told to adhere to on a best-efforts basis until such time as the Level 2 regulation was issued. 

The first of these criteria is that an investment must contribute to an environmental and/or social objective, which – in the absence of clarification from the European Commission – is whatever the relevant asset manager prefers to define and describe for those objectives. 

The second criterion is that an investment – the companies that you invest in – must not do any significant harm to any environmental or social objectives. For example, you cannot invest in a company producing solar panels if they are using forced labour to make them. 

And the third criterion is that companies that you invest in must follow good governance practices. 

These second and third criteria posed a great challenge to a huge number of established ETFs whose investment objectives were to replicate third-party indices, with no ability to eject companies from their portfolios independently of the index if any such companies were discovered to be doing significant harm to environmental or social objectives, or if they were subsequently found to be badly governed. Engagement is not enough to satisfy those three criteria. You have to be able to get rid of problematic companies. So, unless the index replicated by an ETF itself had criteria embedded into its selection process that would eject companies that contravened the ‘do no significant harm’ and good governance criteria, then they would clearly struggle to satisfy all three mandatory criteria of the definition of ‘sustainable investment’ on an ongoing basis.

In terms of the EU Taxonomy alignment, which is totally separate from the issues of Article 9 categorisation under SFDR, we have always known that alignment data was an issue. 

The European Commission has only adopted taxonomy criteria for two of the six environmental objectives. The remaining four environmental objectives are yet to be adopted. 

And with respect to the social side of the EU Taxonomy, the European Commission has only published the three high-level social objectives; it hasn’t adopted any taxonomy criteria for those objectives. Additionally, most companies are not reporting their revenues in a manner that enables taxonomy alignment to be assessed easily by ESG data vendors. So, on the one hand, we are missing the majority of the EU Taxonomy, and on the other hand, we are missing the data that we need from the majority of public companies that would enable market participants to assess taxonomy alignment.

We won’t be getting meaningful additional data from companies until 2025, which is when the next meaningfully sized batch of companies will start having to report taxonomy alignment. Until then, it’s all going to be estimated data for the most part. If you look at the alignment data that is currently available from the major ESG data vendors, alignment is low. Until a greater number of companies are reporting their revenues under CSRD [the Corporate Sustainability Reporting Directive] and the European Commission has adopted the remainder of the Taxonomy criteria, alignment will need to be estimated.

Funds Europe – ETF net inflows have been resilient despite wider market volatility in the past year. Do you see this continuing in 2023?

Hsu – In 2007, I worked at a bank, market making OTC [over-the-counter] swaps where most investors were long-only funds, including global pension funds. As we approached 2008 and with the fallout of Lehman Brothers in that year, there was a quick pivot overnight from investing in OTC products to listed products due to the elevated concerns with counterparty risks. Index-listed products would typically include index futures and ETFs.

On the back of this, we saw more ETFs launched in the market, not just in the US but also in Europe. ETFs are very easy to trade and understand, transparent and relatively low-cost compared to other funds. It’s a technology in itself.

O’Brien – ETFs are ideal tools for changing markets, and volatility will always see investors use ETFs to make that pivot as they are easy, liquid and transparent.

We service over 500 ETFs in the US and we can see trends almost before they appear. That ability to pivot easily is manifesting itself over there in a vast number of ETFs being launched with very specific strategies – inverse, leveraged, caps and floors and in many cases on single stocks. These are more difficult strategies to enact within an ETF in Europe as they don’t fit well in a Ucits structure but I forecast an increased use of exchange-traded notes as the vehicle of choice for such strategies here.

Hsu – I agree with the point about the ability of investors to pivot. For example, bonds are complicated to short-sell in the market if you have a negative view, but you can short-sell a bond ETF subject to borrowing, which gives an investor the flexibility to quickly express a short view in the market or for hedging purposes. It could be hedging of a broader portfolio. 

The flexibility of ETFs as a trading tool is one of the reasons why we think ETFs will continue to gain traction.

Dzanis – 2022 was one of the top-five years for ETF inflows in Europe and we’ve already seen €15 billion in inflows go into ETFs in January alone. What’s interesting has been the split, 50/50 in equity/fixed income ETFs. They gathered €80 billion in net inflows, bucking the trend. Fixed income took 35% of the flows, and even though fixed income represents only 25% of total assets in European ETFs, ESG-oriented fixed income ETFs accounted for 65% of that. So, we are seeing a lot of growth and opportunity.

If you consider recent regulations, we’re talking about investors wanting access, which is about the ability to implement or democratise investing. For example, suppose I look at our FlexShares Listed Private Equity ETF, which is just a year old. In that case, some of the feedback is that if they didn’t have the opportunity to invest in an ETF for a strategy, they might not be able to access it at all, or they might not get the transparency or the daily mark-to-market, or you might have investors waiting on a capital call or seeking to monetise their cash. But they can in a modular way that aligns with their investment strategy. I see the trend of investment managers creating a product to meet needs. Many ESG outcomes are likely involved in new product creation.

“A vast number of ETFs are being launched in the U.S. with very specific strategies – inverse, leveraged, caps and floors and in many cases on single stocks.”

O’Brien – Another trend we see that is related to the ability to pivot quickly through ETFs is the rise of investment platforms. In the US these are in the form of ‘Multi Series Trusts’. We lead in the servicing of such structures in the United States and have clients who can offer ready-made infrastructure to smaller, specialist managers who see the demand and need to move quickly to get to market and capture investor flows. The platforms come complete with service providers and expertise, leaving the manager to focus on distribution and investment strategy. We are already seeing US issuers seeking to launch such platforms in Europe. In some cases, they are linked to distinct distribution specialities that are driven by a new generation of digital investing channels aimed at the retail space.

It’s fascinating and something to keep an eye on. 

Dubos – The ETF is a wrapper. You have good ETFs, and you have bad ETFs. But the wrapper, the project, has shown its resiliency and attractiveness to investors. And that’s the critical point, and I think that’s why we will continue to see probably outflows from mutual funds and inflows into ETFs.

In 2023, we believe actively managed funds will continue to grow significantly and, in time, possibly new distribution channels such as tokenisation, another layer above the ETF. The market is still mainly driven by institutional investors. Still, we will see retail coming to it because the younger generation is also savvier concerning their investments and attracted by the easy access that ETFs offer.

You get value for money with a lot of ETFs versus mutual funds. So, the traditional arguments for ETFs are still very much there. Traditional managers are aggressively pushing into the ETF space. It might be a bit late to launch a plain vanilla passive fund based on well-known indices unless you have a big name. But there’s a lot of room for boutiques to do their own thing through innovative products or just on the retail point in the wealth transition.

O’Brien – Stuart, do you think that the risks that come as the market gets bigger, with firms coming into the market with more and different products and services, mean the quality of products will decline? If the larger asset managers step up to the plate, there is a chance that you’ll end up with lots of little firms doing lots and lots of stuff not particularly well.

“Bonds are complicated to short-sell in the market if you have a negative view, but you can short-sell a bond ETF subject to borrowing, which gives an investor the flexibility to quickly express a short view in the market.”

Forbes – It’s expensive to build an asset manager and reach scale in revenue and costs. The biggest threat to innovation in the ETF market is that the small boutiques, who bring the innovation to the market, get copied by the large, established players before they are able to scale their AuM [assets under management] to a sufficient point of resilience. And this is because there is a huge institutionalised bias towards the largest established ETF providers, which can be explained by the fact that fund selectors have limited time and resources to review asset managers, and so it takes a long time for new market entrants to get in front of fund selectors, build trust and get themselves onboarded as a product issuer (from a due diligence perspective). 

The EU hasn’t done anything meaningful to make it easier for new boutique entrants. It hasn’t done anything meaningful to reduce the regulatory fragmentation (gold-plating) and tax fragmentation that continues to inhibit cross-border distribution and really impact new entrants from penetrating all EU countries efficiently. New entrants also pay higher fees to key service providers than the larger, established players (who already have scale and better leverage to negotiate) and lack the established distribution penetration. 

So, to maintain innovation in the market and encourage new entrants to join, the EU needs to, at the very least, eliminate the fragmentation, prohibit gold-plating by member states and, if possible, create a unified tax system (this last one is obviously a bit of a stretch). Otherwise, the concentration with the largest managers will just get worse. At the end of 2022, a single ETF provider represented 50% of all European ETF AuM, according to Bloomberg. 

Dzanis – It’s not just the wealth transfer. These recent generations are the first generations that don’t have to be the age of most millionaires or billionaires, and they’re making their own money in unique ways. And that’s another facet to this; it’s not just them waiting for wealth to transfer to them. They’re part of the economy, vocal and activist-minded.

Hsu – It is about the scale. If you look at the global ETF industry, the top-three providers account for over 65% of global AuM. If an ETF provider doesn’t have the scale or the ability to get up to scale quickly, it will be difficult to gain any meaningful market share. 

ETF providers need to be constantly thinking about how best to lower costs to stay competitive. How to improve the process overall. How do we leverage technology to improve that outcome? 

© 2023 funds europe

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