Talking Heads – Understanding Active ETFs

This is an edited transcript of the Talking Heads podcast episode Understanding active ETFs

Andrew Craig: Hello and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in depth insights and analysis through the lens of sustainability on the topics that really matter to investors. n this episode, we’re going to be discussing exchange-traded funds or ETFs and in particular active ETFs. I’m Andy Craig, Co-Head of the Investment Insights Centre and I’m joined by Marie Sophie Pastant, who is Head of the Portfolio Management team for ETF, Index and Synthetic Strategies at BNP Paribas Asset Management. Welcome, Marie Sophie.

Marie Sophie Pastant: Hello, Andrew. Happy to be there with you.

AC: Let’s start right at the beginning, by reminding our listeners that an ETF is an investment vehicle that’s basically built like a mutual fund. It can invest in hundreds, sometimes thousands of individual bonds or equities, or other securities. And that is important because it enables diversification. But unlike most mutual funds, an ETF trades on a stock exchange throughout the day. It’s listed on the stock exchange, and it’s therefore regulated by the rules and conditions of that stock exchange. So that’s ETFs. If we just move up a step, could you begin by explaining to us what active ETFs are?

MSP: We need to distinguish between indexed ETFs and active ETFs. Indexed ETFs are replicating the performance of an index. They represent the vast majority of ETFs. However, since a few years now, there are active ETFs in the market. We can consider two sub-categories. The first one is very close to active portfolio management. The objective is to generate alpha.

AC: Marie Sophie, can we just pause for a moment there? Let’s get this completely clear. A traditional standard ETF tracks an index, [it] replicates the securities in that index. It could be the S&P 500 in the US or the DAX in Germany, or the CAC 40 in France. The objective is to replicate the performance of that index. An active ETF is going to aim to generate alpha, so that’s additional return over and above that [of] the index. Is that right?

MSP: Yeah, exactly. Active ETFs are looking at beating the performance of the benchmark. The second category that we considered as active ETF is to be as close as possible of the index, but to have ESG features embedded within the investment process by doing, for example, a screening. We can exclude securities that do not fit our ESG objective. It can be tobacco, it can be thermal coal.

AC: That’s very clear. There’s been a lot of strong growth in active ETFs. Can you talk about that? Why are these funds growing so strongly?

MSP: You’re totally right. First, it is well known in the US and it’s coming to Europe as well. A few figures. It represents 7% in terms of market share. How much do the active ETF represent in terms of under asset management? It’s EUR 45 billion.

AC: That’s very interesting. As is as often the case in finance, developments start in the US. ETFs have come to Europe, which have grown very quickly, and they’ve become an important instrument. I understood that initially, active ETFs were just listed on the stock exchange in Ireland. What’s happened since then? Is that still the case or are they now listed elsewhere?

MSP: Active ETFs were in Ireland at the beginning because only Ireland authorised active ETFs. Then other regulators in Europe are keen on developing this business. France authorised active ETFs at the beginning of this year. Luxembourg from next year is going to remove a taxation for the funds to develop the active ETF business as well. So, regulators are aware of the fact that active ETF is coming into Europe and the growth will be important over the coming years. Just one last figure. Half of all the ETF launches in Europe [this year] were active ETFs.

AC: Could you talk us through the process that we employ for the management of active ETFs? How do you integrate the environmental, social and governance criteria into active ETFs?

MSP: First, we are working with many teams. We are working with our sustainability centre to have all the necessary information in terms of ESG criteria. We are working with the quantitative research team, so the financial engineers, and we are working with our product development team.

The strategy is quite simple. It’s a two-step approach. First to screen the parent index we are tracking. Let’s take the S&P 500. We are removing companies that are not compliant with the ESG profile we would like to have, so,  companies involved in tobacco, thermal coal, unconventional oil & gas, and other activities that we do not want to finance. So, once you have screened your universe, we are performing an optimisation to have a portfolio that presents the same risk characteristics of the initial index to be able to deliver a performance that is as close as possible to the performance of the index.

And we have objectives to beat the benchmarks on ESG criteria: to reduce the carbon footprint compared to the parent index; to have a minimum sustainable investment commitment, to have an ESG score better than the one of the benchmark.

AC: So, we’re screening the initial index to remove those companies [that] do not comply with our ESG criteria. And then you talked about adjusting the risk profile so that we have a portfolio that resembles as closely as possible the underlying index. We know we will have some deviations, but we try to minimise as much as possible those deviations compared to the benchmark. Investors are getting the index, but with an ESG overlay. Which asset classes do we cover with active ESG ETFs?

MSP: We have developed two ranges. On fixed income, we have created products on euro government bonds, euro corporate bonds and fixed maturity products on euro corporate bonds. We’ve got equity products on the S&P 500 and [the] MSCI Europe, MSCI World and MSCI Japan. It’s a comprehensive range covering equities and bonds.

AC: Why do you think active ETFs are so popular? Why are they growing so fast?

MSP: First is transparency: customers have access to the composition of the product. Second, the flexibility: you can trade an ETF for EUR 10, for example,  and you can have a very large diversification because you can trade any kind of strategies. ETFs are affordable. But the cherry on the cake I would say for active ETF is really the flexibility. With our active ESG ETF range, we can match exactly the definition of ‘sustainable investment’ coming from the Sustainability Centre.

AC: There’s clearly numerous advantages: transparency, the fact that the investor can see exactly what is in the portfolio; you can invest relatively small amounts, and you still get exposure to the whole stock market; you can buy and sell quickly, easily and cheaply. And then the speciality that we’re offering is that they apply our specific sustainable investing criteria.

MSP: For me, the best recognitions we have on those products are twofold. First, the confidence of our clients because the assets under management of these kind of strategies represents now more than EUR 1.3 billion. Secondly, we’ve been recently awarded ‘Favourite ETF launch of 2024’.

AC: Congratulations, that’s certainly very good news and we look forward to talking to you again in the future and hearing more about the development of active ESG ETFs. Thank you very much for joining me today.

MSP: Thank you very much for being there with you.

AC: That’s it for this week’s episode of Talking Heads. If you would like more information about our active ESG ETFs, please reach out to your BNP Paribas Asset Management contact or check out Viewpoint, our website for investment insights at www.viewpoint.bnpparibas-am.com.  You’ve been listening to the BNP Paribas Asset Management Talking Heads podcast with me, Andrew Craig, and Marie Sophie Pastant, Head of the portfolio management team for ETF, Index and Synthetic Strategies at BNP Paribas Asset Management. Take care and please do join us again.