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Transition ETFs have emerged as a popular tool for investors seeking to align their portfolios with sustainability goals following a string of launches in recent years.

These ETFs vary in how stringent their ESG screens are and some have faced criticism over whether they genuinely contribute to the climate transition or simply act as a tick-box exercise for investors.

BlackRock, DWS and UBS Asset Management (UBS AM) are the big hitters in the space and have all launched strategies within the last two years.

BlackRock unveiled a five-strong climate transition ETF range in June this year, tracking the MSCI Transition Aware Select index suite, with the aim to provide broad market exposure while aligning with climate transition goals. They are classified as Article 8 under the Sustainable Finance Disclosure Regulation (SFDR).

Three months before, the UBS ETF (IE) S&P 500 Climate Transition ESG UCITS ETF (CT5G) was launched, drawing its constituents from the S&P 500 index that are “compatible with the transition to a low-carbon and climate resilient economy”. It is classified under Article 9 under SFDR.

Finally, DWS unveiled a six strong range of Climate Transition Benchmark (CTB) strategies with regional focuses, completing the range in October 2023. Climate transition ETFs provide investors with a way to engage in ESG-focused investing without always deviating too significantly from parent benchmarks.

ETF Stream spoke with fund selectors for their views on this emerging product class and evaluated how effectively these ETFs contribute to advancing the climate transition.

Defining transition ETFs

Zooming out slightly, the concept of ‘transition’ in investing can be understood in two ways. Investors may focus on identifying companies that are actively undergoing their own company-level transition, or they may target technology, commodities and materials essential to driving the broader energy transition.

“It is going to be a commodity intensive transition,” said Patrick Thomas, head of ESG portfolio management at Canaccord.

He explained the energy transition relies on the idea that “dirty” commodities must play a role in becoming “clean”.

This means that achieving full electrification will require huge amounts of copper, aluminium, lithium and other materials essential for batteries.

“This process will be highly commodity-intensive, and any approach that ignores this reality fails to grasp the scale of what is needed for electrification,” said Thomas.

Paris Jordan, head of responsible investing at Charles Stanley noted commodities are a little harder to capture than equities through the complexities of the futures market.

As such, transition ETFs capturing equities are popular among investors. Thomas noted an equity-focused transition ETF could mean “companies that make up transition indices that appear very similar to the type of companies that are in traditional indexes like the MSCI world”.

“It could just mean that those companies, from reporting, policies and procedures perspective, are more likely to transition less disruptively to net zero scenario.

“What they are effectively doing is they are providing broad market exposure but following some kind of low carbon benchmark,” he added.

Both Thomas and Jordan agreed a key issue is these strategies are not advancing the climate transition, though with slightly different perspectives.

Thomas argued that these products often end up being “much more expensive” because they are not just replicating a traditional index but incorporating additional complexities, which drives up costs.

Taking a broader stance, he also questioned: “How much of it is actually a transition ETF and how much of it is just a framework for thinking about companies transitioning to a net-zero scenario?”

“If lots of companies were already in a brilliant place to transition to a lower-carbon economy and help the world decarbonise, the climate issue would not be as big a problem as it is.

“There is a relatively small number of companies that are truly capable of helping the world transition, and many of them are in harder-to-decarbonise sectors.”

Taking a slightly different angle, Jordan identified a passive approach as a key hurdle.

“The challenge for passive funds to meet the sustainability threshold is great, as their primary goal is to track an index within a specific tracking error range.”

“Even if you are doing tilting, it might look marginally better compared to the tracked index, but how much impact, how much change, how much transition is it actually going to support? Not that much.”

She added that if everyone shifted to a transition-tracked index instead of a standard one, “then, incrementally over time, or theoretically it could make a difference. But we are probably talking hundreds of years, because of the makeup of the benchmark”.

In the same breath, she noted transition ETFs do mark a step in the right direction.

What is the best approach?

The active versus passive debate extends firmly into the realm of ESG investing. The debate over whether a broad, large-scale passive approach to ESG ETFs or whether the more focused strategy of active manage[1]ment is more effective has been a prevalent topic in recent years.

Yo Takatsuki, global head of investment stewardship at JP Morgan Asset Management (JPMAM) previously told ETF Stream engagement holds significant potential to drive meaningful real-world outcomes.

“Engagement is the best way to generate the ESG win-win of owning companies which over time deliver good risk-adjusted returns while minimising the negative impacts on society and the environment.”

Jordan highlighted the need for active management to demonstrate its value through sustainability and transition efforts, stating: “The only thing that is really going to save active management is showing you are being active with your capital.”

Jordan also noted that ETFs are generally aligned with passive investing, making it harder to assess management strategies since they rely on quantitative measures, which often have significant gaps in quality and consistency.

Finally, Thomas added that while shareholder engagement can drive improvements in reporting and disclosure, evidence of it leading to meaningful behavioural change in companies is scarce.

“Claiming a product is driving significant change is a big claim and not easily verifiable. Even for active managers running open-ended products or investment trusts, engagement can be challenging, even for large shareholders.

“The key takeaway is that while engagement does work, it is difficult, often time-consuming and not always clear that specific products effectively drive meaningful change.”