Socially Responsible Investing – the New Wave of ESG Index Funds
(A Summary – See the Full Text of the Paper on our website: plumstreetadvisors.com)
By David Dirks and Jamie Osborn
In recent years there has been growing interest in socially responsible investing (now commonly called Environmental/Social/Governance, or “ESG” investing), but one of the primary barriers has been the higher cost of ESG investments. As supporters of low-cost index investing, this has made it difficult for us at Plum Street Advisors to recommend a comprehensive ESG portfolio. However, in the past two years, the landscape has seen a seismic shift. Large index fund providers like iShares and Vanguard have launched low cost ESG index funds in a range of asset classes, from stocks to bonds, from domestic to international, and from small to large. The growth of ESG exchange-traded funds (“ETFs”) has been explosive over the past two years, growing from 25 available ESG ETF funds in the market at the end of 2016 to 69 ETF funds at the end of 2018.
This explosion in growth of ESG index funds has been enabled by the increasing availability of ESG indexes, which allow large fund providers to create low-cost products based on a passive simulation of an index (much like the Standard & Poor’s 500 Index serves as the basis for low cost S&P 500 funds). Development of the ESG indexes, in turn, was enabled by growth in the availability of ESG metrics about companies, gathered from government entities, non-profit groups, media sources, and company disclosures. As a result, an investor can purchase a US Large Cap ESG Fund at a cost point that is comparable to non-ESG funds.
In this paper, we explain why we think the time has come to seriously consider ESG investment. First, we discuss how ESG investment helps to align a portfolio with your values. Second, we talk about the pros and cons of ESG investing: performance, portfolio construction, and cost. Finally, we talk about various approaches to building an indexed ESG portfolio that works for you. The following summary of the paper covers the highlights.
There are three primary reasons you might wish to invest in ESG:
- You have a moral desire to support companies aligned with your values.
- You want to influence a company’s actions with your investment dollars.
- You believe that in the long run, ESG investments will be more sustainable and therefore have superior long term returns.
Socially responsible funds used to exclude the stocks of certain objectionable industries and then rely on a portfolio manager to build a portfolio from the remaining available companies. The increasing trend in ESG funds is to look more deeply into individual companies and is based on the concept of sustainable investing. While certain industries might still be excluded entirely (i.e. tobacco, weapons, or coal stocks), index ESG funds generally use a ranking system that takes a range of factors into account and emphasizes the inclusion or overweighting of stocks that have the best scores for companies in their industry based on the following key areas:
The new wave of indexed ESG funds relies on a set of rules to select its investments. All the companies included in the traditional index are ranked based on selected ESG criteria, and the index constructs its holdings based on these rules. The approach is more comprehensive and consistent than the traditional portfolio manager-led approach, but in order to be able to rank every company, it required wide availability of the data the rankings are based on. This company ESG data has become vastly more available, which has helped to drive the growth of ESG index funds. The resulting index funds, just like their non-ESG counterparts, are significantly cheaper to run and are much more predictable as far as how they will behave as compared to the overall market.
Generally speaking, ESG indexes have certain characteristics as compared to their non-ESG counterparts. They have a tilt toward growth stocks because they are often over-weighted in “clean” sectors like IT (although most will limit how much overweight they can be in any sector), and they tend to move in the opposite direction of certain “factors” (like oil prices) because they favor companies with less energy exposure. These characteristics may cause a portfolio of ESG funds to behave differently, albeit in somewhat predictable ways, compared to a portfolio made up of more traditional indexes. At Plum Street Advisors, we can help you to estimate just how far off an ESG portfolio is likely to stray from a standard portfolio over a given period, and adjust the mix depending on your tolerance for this so-called “tracking error”.
Building an ESG portfolio is a more personal, customized endeavor than building a traditional portfolio. Not only do we have to consider things like the risk and return, but we also need to consider which environmental, social, and governance issues are important to you and how much deviation from standard performance you are willing to accept. The good news is that the new wave of ESG funds has given us much wider choice of funds and asset classes at much better pricing and with much greater transparency (since the fund has to be clear about the rules built into the indexes) allowing us to build diversified, low-cost, transparent portfolios.
For many years, ESG has been a much greater percentage of the talk of investors than of their dollars. Institutional ownership of ESG portfolios was largely the domain of either religious institutions or portfolios with very limited exclusions (like tobacco-free funds). This is now rapidly changing, as ESG investing has caught on and the cost of ESG investing has declined dramatically.
The growth of ESG–led by European pension funds and insurers—is increasingly being adopted by US institutional investors, and will likely be followed by more material retail growth in ESG mutual funds and ETFs. There are now over 350 ESG mutual funds and ETFs available, representing $89 billion in assets. The ground-breaking change from our perspective is that many of these ETFs are based on broad indexes at low fees and it is now possible to build ESG portfolios using mutual funds and ETFs in almost every asset class that are competitive with portfolios based on standard indexes.