ETF Investing With A Social Impact

Investors may get additional emotional satisfaction from socially responsible investing.

[This article appears in our March 2019 issue of ETF Report.]

There’s growing evidence suggesting investors who incorporate environmental, socially responsible and governance (ESG) metrics may outperform traditional indices.

But what do investors get out of ESG approaches besides saying they do well by doing good? Turns out there’s more to ESG investing than simply performance.

ESG market watchers and participants say there are interlacing benefits people get from this investing theme. There are financial benefits, as ESG investors look at both what companies make and how they are run, often choosing high-quality firms. Benefits can be emotional and values-driven, as people choose their investments to align with other life choices.

And it can encourage investors to take a more hands-on approach to their portfolio, to really understand their holdings, rather than blindly letting a fund manager or an advisor do the work. That attachment can keep people invested during all market cycles, improving outcome odds.

Honing In On Return Drivers

Jon Hale, global head of sustainability research at Morningstar, says that because there are so many ways to apply ESG factors, it can be hard to pinpoint exactly what drives financial results, but many indices are constructed with higher-quality companies that often have lower volatility, which can be positive investing characteristics.

Then there is the behavioral side to this investing style. “Average investors, individual investors get other benefits out of [ESG] investing,” he said. “Investing is not purely utilitarian; it’s not purely about just what your bottom line is.”

Hale says that in the initial era of popular investing—the mutual-fund era of the 1990s until the 2008 financial crisis—individual investors were instructed to listen to financial market experts about how to invest, and to not bring their own values in; otherwise, that would skew performance. But he says that advice is misguided, as it ignores the way people make other financial decisions.

He used another example of how investment decisions aren’t always bottom-line driven: “There are a lot of people out there who are bargain shoppers when they spend money. They love to … buy low-fee investments. It’s not purely for this narrow reason they think they're always going to outperform; it's because they feel like they're getting a bargain for it, and that makes them feel good.”

Sarah Kjellberg, head of BlackRock's iShares Sustainable ETFs, says portfolio construction principles “do not go out the window,” when it comes to ESG investing. Rather, entire portfolios can be built in a way that aligns with an investor’s overall motivation, and there’s no a one-size-fits-all approach.

Whole Portfolios, Not Niches

ESG is still sometimes perceived as a sleeve in a total asset allocation, made up of niche satellite holdings, focusing on, say, clean water or renewable energy, rather than constructing core holdings and adding satellite investments. But as ESG has evolved, ETF issuers are building complete ESG portfolio offerings, making it much easier for investors to build diversified portfolios, Kjellberg says. But education is still needed.

“We have these asset allocation building blocks ... and various satellite exposures like low carbon or impact investing,: she said. “We have these choices and it's really incumbent upon the asset management community to help investors think these through.”

Kjellberg also says that investors interested in ESG don’t want to just dip a toe in the socially responsible investing pool, they want to dive right in completely.

“From our experience—and particularly working with financial advisors—what we’ve found is that their clients are seeking ‘full activation’; they want 100%,” she noted, adding that BlackRock works with financial advisors to create transition-type portfolios to avoid tax consequences of switching products from traditional investing to ESG.

Governance Is Key

Vince Birley, chief executive officer of Vident Financial, says many ESG investors may have an edge over others when seeking companies with strong governance. While no one has come to them saying specifically they want companies with strong leadership, their investors see how corporate leaders who focus on short-term results by cutting corners or hyping earnings may hurt long-term performance.

“I think our markets are having to mature beyond just getting access to capital and getting on the top 500 list so they can get money flow,” he said.

Governance-focused companies think about being fiduciaries and not just owners, realizing there’s a responsibility beyond just growing earnings. “It's a big transition that's taking place that I think people aren't really tuned into in general,” Birley added, which gives ESG investors that edge.

Early ESG ETFs were passive vehicles giving investors access to companies that scored well on environmental, socially responsible or governance metrics. But the newer impact ETFs seek greater engagement with companies to improve behavior, which can give investors greater social and financial benefits.

“If it's just an ETF that's tilted toward companies based on ESG evaluations, and doesn’t do any kind of engagement, it’s not really concerned about impact; you're really not getting the full effect,” Morningstar’s Hale noted. “But some are. So that's the job of an advisor or an analyst to try to sort out.”

Moral Conviction = Commitment

Dave Nugent, chief investment officer of Wealthsimple, says that over 20% of the digital platform’s clients choose to have a socially responsible investment portfolio. He notes there’s some research to suggest investors who choose ESG perform better in the long run, because they believe in what they¹ve invested in: “It's not just about returns. This means they're less likely to pull their money out in a downturn, which leads to better returns.”

Hale says his personal belief is that ESG may make people better investors, although he’d like to see more academic research on the idea. He notes that people who more closely identify with their investments could be more likely to consistently invest over time.

“If you think you're investing in the better companies that are lower risk and that are higher-quality companies, and you see evidence about their positive behavior and sustainability efforts and things like that,” he said, “then that's definitely a company you wouldn’t divest out of at the first sign of some kind of market decline.”

There’s some evidence ESG investors sit tight in shaky market conditions, albeit on the mutual fund side. A 2015 blog post by Lipper said socially responsible investors were more likely to stick with their holdings during the bursting of the tech bubble from 2000-2003 and the 2008 financial crisis.

Lipper noted conventional equity mutual funds had net redemptions for 2002 and 2008, while SRI funds had net inflows for both periods. Total net assets in SRI funds fell because of the market losses, but these investors seemingly saw the dip as a buying opportunity, as, after reaching a low in 2008, total net assets rose 121% by 2015.

BlackRock’s Kjellberg says this stickiness goes back to this dual focus that ESG investors have: financial and purpose-driven.

“It's long-term thinking; we weather the storm and hang on to these investments that you believe are really geared towards delivering long-term value,” she explained. “And then there's the other side of that, which I think speaks to someone's values. … They're investing in it because they believe it’s advancing things they ultimately care about.”