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Morgan Stanley to Enter ESG ETF Space

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In August 2022, Morgan Stanley filed with the SEC to launch six ESG ETFs, its first foray into the U.S. ETF space since its pioneering WEBS products were introduced in the 1990s. The proposed ETFs are likely to be listed in Q4 2022 or in early 2023. The ETFs are being launched under the Calvert asset management sub-brand, which became part of Morgan Stanley as part of its 2020 acquisition of Eaton Vance. Calvert is an ESG focused manager that has been successful in the traditional mutual fund space. Earlier in 2020, Morgan Stanley had acquired E*TRADE Financial, broadening its retail wealth footprint. In aggregate, MS’s proposed ETF launches and recent corporate acquisitions indicate an intent to grow its wealth and investment management franchises, which together represented about 50% of the firm’s revenues in 2021.

The six proposed ETFs consist of four indexed equity ETFs and one active equity ETF as well as one active bond ETF and appear to be positioned as core portfolio holdings.

ESG Category: Stuck in neutral

A year ago, ESG seemed poised for takeoff and was expected to become a larger part of investor portfolios in the U.S. This was reflected in the rush by ETF issuers to launch new ESG funds. Of the 252 ESG focused ETFs listed in the U.S. as of Sept. 8, 2022, over 60% were launched after Jan. 1, 2020.

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However, as of September 8, 2022, equity ESG ETFs accounted for only 1.96% of all equity ETF assets in the U.S., only a marginally higher share than a year ago, despite the increased product availability (see Table 2).

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The reasons for the slower than expected uptake are unclear, although it is likely that in 2022 investors were focused on more immediate macro factors like the Ukraine conflict, inflation and rising rates. Also, oil and gas stocks have performed well this year, and the ESG ETF constituent holdings either do not include or tend to be underweight in the energy sector.

Specialized competition

Morgan Stanley will also have to contend with more focused competition from entrenched players like Blackrock. Interestingly, in the ESG equity ETF category in the U.S., Blackrock has a dominant market share of 56% as of September 8, 2022. This contrasts with the broader equity ETF space in the U.S., where Blackrock has a relatively lower 32% share. Vanguard and State Street (SPDR), Blackrock’s primary competitors in the U.S., do not have a very significant ESG footprint and have more assets in core equity ETFs.

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The absence of dominance by Vanguard (so far) in the ESG space may be a potential opportunity for newer entrants like Morgan Stanley to make an impact. Vanguard’s relatively lower presence has also reduced fee-based competition, unlike in core equities where fee compression has squeezed profitability for asset managers.

Other ETF issuers besides the Big 3 have also had success in the ESG space. As of September 8, 2022, Invesco, DWS and Nuveen all had between $4B and $5B in ESG ETF assets in the U.S. Morgan Stanley will face targeted competition from some of these issuers as well.

Significant headroom for growth

The ESG space still has fundamental definitional and ‘philosophical’ issues to be resolved. For example, does ESG mean excluding certain high carbon sectors such as oil & gas entirely, or selecting the ‘best of the worst’ from these sectors. These are not easy choices, since it may result in tradeoffs between fidelity to ESG principles and performance, such as in 2022 when energy stocks have performed well. There is also no agreement on what those ESG principles should be, and there is unlikely to be a uniform consensus on this. However recent proposals from the SEC regarding the names rule and ESG disclosures in prospectuses could enhance methodology transparency and encourage more investment in the space.

Although the ESG ETF space has been treading water in the last year, its low penetration implies it has significant headroom for growth. As of Sep 8, 2022, no S&P 500 based ESG ETF had more than $1B in assets. By contrast, the three core S&P 500 ETFs (SPY, IVV and VOO) had over $930B in assets as of the same date. Similarly, the iShares ESG Aware MSCI EAFE ETF (ESGD) has only $6.3B in assets relative to the two non-ESG iShares EAFE ETFs that in aggregate have $125B in assets as of Sep 8, 2022. Any incremental shift by even a segment of investors to replace their core equity holdings with an equivalent ESG version will result in very significant inflows into the category.

Recent macro developments could also benefit the category. The Inflation reduction act resulted in significant inflows into clean energy ETFs, with net inflows of $610M in the last 3 months. This new legislation could also benefit broader ESG ETFs.

Looking ahead

With less than 2% of U.S. equity ETF assets as of September 2022, the ESG industry is at an interesting crossroad. It is unlikely that all investors will have uniform definitions or preferences regarding ESG. This implies that they will need a range of possible ETF options, with differing methodologies and underlying philosophies, to choose from. If these ETF product choices do not adequately meet their needs, investors may opt for other routes such as separately managed accounts or direct indexing. The launch of Morgan Stanley’s ESG ETFs will be an interesting inflection point in this journey.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.



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