How to use ETFs for responsible investing
Long before people were talking about factor investing, there was an interest in socially responsible investing (SRI) filters. In my practice, clients have been looking for environmentally friendly investments since long before the 2008 crash.
There were few options available at the time. Most were in the form of mutual funds and they were usually bought by the client, not sold by the advisor. Further, clients usually took the initiative to ask about SRI: they would ask if we could help them invest responsibly, and then we would look for product.
Fast forward to 2019 and SRI — now more commonly referred to as ESG (ethical, social and governance) investing — is much more than just an investment fad. According to research by MSCI Inc., global assets under management for ESG ETFs reached $31 billion as of September 30th 2019, up from $20 billion at the end of 2018 and $16.6 billion at the end of 2017.
The demand for ESG products crosses demographics. I witnessed more than 500,000 people of all ages march for climate change action in Montreal with activist Greta Thunberg on Sept. 27. Not only are my young adult children very concerned about climate change, so are many adult children of our clients — in addition to companies, institutional pension funds and governments around the world. Often, clients who begin inquiring about introducing their children to investing will mention that they would like to use environmentally responsible investments.
As a primarily ETF-based discretionary portfolio manager, I have taken on the challenge of building ESG portfolios for interested clients.
Clients who are looking for an ESG solution often have specific demands regarding what they will and will not tolerate in their investment portfolio — no oil, no firearms and no cigarettes are sometimes just the beginning. It can become difficult to tailor portfolios to individual investor tastes and almost impossible to build ESG discretionary models, since clients will often want some sort of customization to fit their beliefs.
For advisors looking to grow their practice by entering the ESG space, my suggestion is to start with an ESG methodology that allows you to speak with conviction to clients about your investment philosophy.
I was attracted to ETFs because of my belief that the less emotion in the investment process, the better the outcome. I believe in the rigor of the index building process, regardless of the underlying construction methodology. I think of ESG-focused ETFs as a form of factor investing, where the environment for stock and bond selection is created from an ESG-filter overlay from which the index is subsequently constructed.
Several ETF issuers now offer ESG products. The filters are ESG, but the underlying index construction methodology varies. Some ETFs might be more focused on excluding certain types of companies. Another ESG strategy is integration-focused, where a rating system is used to select companies that rate highest on an ESG scoring system. Then there is impact investing, which focuses on buying companies that intend to generate a measurable, beneficial social or environmental impact alongside a financial return.
Given the variety in these different approaches, it’s important for advisors to run them through their due-diligence process in order to select the strategy or strategies where they have the most conviction. Ultimately, the approach that will work best with clients is the one you believe in.
In my case, having focused my discretionary portfolios on broad-based index models, I prefer to enter the ESG space using a methodology that is integration-focused, at the very least, for core portfolio holdings. This type of index construction usually ensures that all index sectors continue to be represented, with an emphasis on ESG best-in-class, as opposed to excluding a sector or being heavily underweight the general index. This helps ensure that performance will not deviate greatly from the traditional index.
Today, the product offering is growing and good enough that we can build globally diversified portfolios with both stocks and bonds within different ESG frameworks using ETFs and mutual funds.
These types of ESG filters might not be enough for some clients who want to vet every name that goes into a portfolio. As a portfolio manager, I cannot be all things to all people. Clients who want to pick and choose their ESG names can do so outside of our discretionary portfolios; however, we make sure the client knows whether or not we are in a position to provide them with the necessary support to follow their holdings. If not, and the client is doing most of the legwork, it might be in their best interest to consider a discount brokerage account for trading.
To avoid paralysis by analysis, I tell clients that it’s important to start somewhere. By using ESG products in some or all of their portfolio, they are making an important statement about what they’re prepared to invest in.
In most cases, it is also possible to show clients that they are not compromising the return on their investments by using ESG strategies. In fact, there is good reason to expect that outperformance is a distinct possibility.