In another of our ongoing series of insights looking at investing using exchange-traded funds (ETFs), we look specifically at how these vehicles can help achieve investors’ environmental, social and governance (ESG) objectives.
Very broadly speaking, ESG-focused investors often use ETFs in three ways. As a core portfolio holding, as a ‘tilt’ within a portfolio to obtain a more modest exposure, or as a targeted allocation to a particular theme.
The ESG ETF universe is large. Investments can range from a broad global equity index with exclusions, a Paris-aligned climate benchmark, a green bond fund, a corporate bond ESG fund, a clean energy fund, or a highly specific thematic vehicle.
This wide range is useful, but it also means due diligence is vital. Two similar looking ETFs may have “ESG” in their names, but they can have very different holdings, exclusions, sector exposures, tracking errors and income characteristics.
For many ESG investors, the simplest approach is to use is a core ESG allocation. To do this, instead of buying a standard (say) global equity ETF, the investor buys an ESG-screened version. These funds typically take a market index (e.g. FTSE 100) and then exclude or underweight any companies or sectors that breach defined values-based, regulatory or reputational thresholds. Typical exclusions include controversial weapons, tobacco, thermal coal, severe governance controversies or poor ESG ratings. This allows the investor to maintain a broad market exposure while aligning the portfolio more closely with their ESG investment objectives.
An alternative is a ‘best-in-class’ strategy where companies are selected with stronger ESG scores relative to their sector peers. This can preserve sector diversification better than simple exclusions, but it relies heavily on ESG data quality and scoring methodology, which is not always as clear and unambiguous as it could be.
For investors looking for a more focused or ‘thematic’ approach, there are also plenty of options to choose from.
Investors with climate-related objectives may be interested in ETFs that track Paris-aligned benchmarks, climate transition benchmarks or low-carbon indices. These aim to reduce carbon intensity, increase exposure to companies better aligned with a lower-carbon economy, and reduce exposure to issuers considered inconsistent with transition objectives. These ETFs are particularly popular in Europe because of regulation, institutional net-zero policies and climate reporting requirements.
Green, social and sustainability bonds are a major fixed-income theme. Green bonds finance environmental projects, social bonds finance social objectives, while sustainability bonds combine both. For income-focused ESG investors, this is an important area.
ETFs focused on clean energy and environmental solutions cover renewables, solar, wind, hydrogen, battery storage, energy efficiency, water infrastructure and waste management. While social themes can include health and wellness, labour standards, affordable housing, education, financial inclusion and supply-chain ethics.
ESG investing is often wrongly associated only with growth equities or lower-yielding equity funds. However, for investors seeking income the ESG ETF universe includes a range of options across asset classes.
In fixed income, ESG investors can access income through corporate bond ETFs, green bond ETFs, social bond ETFs and sustainability bond funds. These can still provide attractive yields when underlying bond yields are high, but the investor must manage interest rate risk, credit risk, and liquidity risk.
In equities, income can be more complicated. ESG screens may exclude some historically high-dividend sectors, such as tobacco, oil and gas, mining companies, defence, or gambling. This can reduce the natural dividend yield of the fund, but income is still possible through sectors such infrastructure, utilities, or listed real assets.
Despite some regions/countries taking what might be described as an ‘anti’ ESG stance, ESG investing remains in generally favour, but it is certainly less fashionable, more politically contested, and more performance-sensitive than it was in 2020–2021.
Moreover, as ESG investing has evolved, investors are more comfortable asking difficult questions about performance, greenwashing, data quality and whether ESG labels deliver the intended exposure. Regulation is also forcing managers to be more precise. In the UK, the FCA’s Sustainability Disclosure Requirements are designed to improve investor trust and reduce greenwashing in sustainable investment products.
In terms of ESG fund-flow data, the regional picture is very uneven. In Europe it remains popular, helped by regulation, institutional demand and investor expectations. In Asia, appetite is mixed, while, unsurprisingly, the US is the weakest major region for ESG-labelled funds as political backlash, performance concerns and scepticism over ESG branding have all reduced demand.
We have covered the general advantages and disadvantages of ETFs in earlier Insights. But of the advantages relating to ESG investing, ETFs make it easy to build model portfolios, tilt exposures, switch allocations, and blend multiple ESG themes at relatively low cost. Transparency is another benefit. Index ETFs normally disclose the index methodology and holdings frequently, which helps investors assess if the ESG exposure is credible.
The disadvantages are equally important. ETFs may also be less suitable where the investor wants more active stewardship, bespoke exclusions or fundamental ESG research. Passive ESG ETFs follow an index and do not usually make company-specific judgement calls beyond the index methodology. There is also a risk of over-concentration in fashionable themes. For instance, a clean energy ETF may be volatile, expensive at the point of purchase, or heavily exposed to a narrow set of companies.
Overall, ESG-focused investors can use ETFs effectively, particularly for low-cost core exposure, climate alignment, thematic allocations and sustainable fixed income. ESG can still generate good income, especially through bond, credit and green/social/sustainability bond ETFs, but income should be assessed through the normal lens of yield, duration, credit risk and diversification.
Any readers wishing to discuss how our advice can help them use ETFs to achieve their ESG investment objectives, please contact us at info@arlingclose.com.
05/06/2026
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