2017: Year Of Socially Responsible ETFs

Every year, Matt Hougan and I give the keynote address at InsideETFs. Sometime about a month before the conference (that is, right about now), we begin an endless series of arguments about what we think the most important issues are in ETFs, and what that means for investors and advisors for the next year.

One of the strong contenders—at least from my side of the argument—is investing based on environmental, social and governance factors (generally shorthanded to “ESG”), and also commonly referred to as “socially responsible.” With two interesting sessions on the agenda already, it seems inevitable there will be some great discussion to be had down in Florida.

Alphabet Soup

One of the biggest issues with ESG is definitional—much like “smart beta.”  The phrase gets tossed around to include any number of potential products, from funds that explicitly invest based on a particular religious belief system to those that simply remove “sin stocks” and those that choose companies with strong pro-labor policies.

This definitional problem remains one of the great plagues of ESG investors, but it’s almost inevitable. Individual investors can often find easy common ground: Downside volatility is generally bad. Performance, strong balance sheets and momentum are generally good. Taxes? Always bad.

But in the 1980s, when ESG got its start, some of the largest pensions and endowments began to think about noneconomic issues in their portfolios, and the discussions were extremely targeted. Harvard sold out of Citicorp debt to protest South Africa’s apartheid, followed by states and municipalities outright barring any investment in South Africa.

Definition Debate

Later in the decade, big pensions started using their proxy powers to force action from firms like Exxon on specific, targeted issues, like the Valdez spill response.

Through the 1990s, dozens of small firms started cropping up to rate and rank individual firms based on everything from environmental impact to labor friendliness to executive compensation policies.

This slow burn of narrow, individualized ESG definitions has led us to a world where no two people can agree on what ESG even means. For example, inside MSCI’s monster index factory, there are more than 700 indexes on offer with some sort of ESG or values-based screen, ranging from Shariah-compliance to low-carbon output.

Investors, It Turns Out, Do Care

So far, the drivers in socially responsible investing have remained institutional, but they’ve been strong.

Pensions and Investments Magazine devoted an entire issue in April to the topic. The Global Sustainable Investment Alliance, which tracks the institutional use of ESG strategies, published in its last biennial study in 2014 that ESG assets stood at $21 trillion globally, up 61% from 2012. They estimated at the time that 87% of those assets were institutional.

A separate study by the U.S. SIF Forum for Sustainable and Responsible Investment found that U.S. investment in ESG strategies grew to $8.7 trillion in 2016, up 33% since 2014.

And while there have been niche providers in the mutual fund space for ages, the ETF industry is just catching up. Nuveen launched five ESG ETFs earlier this week, on the heels of recent launches from Oppenheimer, iShares and SSGA. And while many of these funds will be used by individual investors, institutions still play a strong role in getting them to market.

The SPDR SSGA Gender Diversity Index ETF (SHE) was actually a joint project with one of the biggest institutional backers of ESG: CalSTRS, the California teachers retirement fund. The pension fund seeded it with $250 million.

Some Advisors See The Potential

As for advisors? The smart ones, like Ritholtz Wealth Management, are launching sleeves of their wealth management business focused on ESG.

So, sure, the industry is behind it. But let’s be honest: The industry gets behind things because they believe that’s where the money’s going to be. And I’ve seen two pieces of data that make me think this is going to really be the year ESG takes off.

The first is a simple survey done by FactSet. The study talked to a broad range of high net worth individuals about their attitudes around investing, and one question in the survey asked about ESG (you can read the whole thing here): “To what extent do you agree that your portfolio should be managed and allocated in a socially responsible manner?” 

That’s a lot of millennial love. And that group is about to start getting a lot of money. According to a recent Accenture study, some $30 trillion will transfer over to millennials in the next 40 years, and at its peak, 10% of the wealth of the U.S. will be changing hands every five years.

Even now, we’re seeing over $1 trillion scheduled to shift in the next few years. That’s money transferring to a generation that favors ETFs, that favors technology and that, it turns out, favors socially responsible investing.

Planting Seeds

That’s why the ETF industry is jumping on board. Initially, assets won’t blow the doors off. There will be some successes—SHE now sits at just under $300 million, most of it owned by CalSTRS—and a lot of slow growth initially.

But the smart firms will be well-positioned when those “mass affluent” millennials go from having nice portfolios to “honey, we need an advisor” portfolios as they inherit.

At the time of writing, the author held no positions in the security mentioned. Contact Dave Nadig at [email protected].