The Least Expensive ESG ETF Portfolio

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

Once upon a time, former ETF.com CEO Matt Hougan wrote a regular feature for the site called “World’s Cheapest ETF Portfolio,” in which he constructed a broadly diversified portfolio using the least expensive ETFs in each of six asset classes. In 2017, Hougan reported the cost of his theoretical portfolio to be at 0.05%.

His portfolio wasn’t so much an investable model as it was a metric: a quick-and-dirty gauge of how the fee wars were impacting the industry.

What he found is that, despite the ongoing fee wars, some areas of the market still tend to be more expensive than others. That goes double for “socially responsible,” or environmental, social and governance (ESG) investments, which can be significantly costlier than their vanilla counterparts.

This may be changing, however. Recently, BlackRock lowered prices on a number of its socially responsible ETFs, including the two largest funds in the space, the $1.3 billion iShares MSCI KLD 400 Social ETF (DSI) and the $828 million iShares MSCI U.S.A. ESG Select ETF (SUSA).

Meanwhile Vanguard, the 800 lb. gorilla of ultra-low-cost investing, finally tossed its hat into the ring with two new funds: the $135 million Vanguard ESG U.S. Stock ETF (ESGV) and the $98 million Vanguard ESG International Stock ETF (VSGX).

That’s why I decided to crib Matt’s idea for the socially responsible investment space. Was it even possible, I wondered, to build a broadly diversified portfolio using only socially responsible ETFs?

Spoiler alert: Yes. Better yet, the whole thing costs just 0.167%.

Building An All-ESG ETF Portfolio
To construct my Hougan-esque portfolio, I picked the ESG ETF offering the cheapest and broadest exposure in each of six asset categories, with no consideration given to benchmark, liquidity, assets under management or even trading costs. Expense ratio was my only guide.

The resultant portfolio provides exposure to more than 2,500 stocks from 35 countries, as well as 178 U.S.-domiciled bonds. What’s more, its blended expense ratio of 0.167% costs less than a third of the average equity ETF (0.54%) (see Figure 1).

New Kids On The Block
My portfolio gets its 75% equity allocation from three broad-based funds: ESGV, the Xtrackers MSCI EAFE ESG Leaders Equity ETF (EASG), and the iShares ESG MSCI EM ETF (ESGE).

ESGV, which debuted last September, screens U.S. stocks across the size spectrum for socially responsible credentials. With an expense ratio of 0.12%, it costs 0.03% per year less than the next nearest competitor.

For international equity exposure, we turned to the $7 million EASG, which costs 0.14%; and the $437 million ESGE, which costs 0.25%.

EASG and ESGE apply socially responsible screens and rankings to the uber-popular MSCI EAFE Index and the MSCI EM Index, respectively.

Notably, both are significantly cheaper than the best-known vanilla ETFs tracking the same benchmarks: The iShares MSCI EAFE ETF (EFA) costs 0.31%, while the iShares MSCI Emerging Markets ETF (EEM) costs 0.67%.

More Green Bond ETFs
Another 15% of our portfolio is devoted to fixed income. The second half of 2018 saw the launch of several new broad-based green bond ETFs, both domestically and globally focused.

Cheapest among these was the iShares ESG U.S. Aggregate Bond ETF (EAGG), a green-screened version of the Bloomberg Barclays U.S. Aggregate Bond Index (the “Agg”), which costs just 0.10%.

EAGG screens the corporate and government bonds in its mix for ESG factors, such as the issuers’ involvement in tobacco, weapons and “severe business controversies.” The remaining portfolio is then optimized to maximize its overall average ESG score, while maintaining marketlike exposure.

Limits To Socially Responsible Coverage
When it comes to the real estate and commodity categories, which together comprise 10% of the model portfolio, I had to fudge things a little. That’s because, at the moment, there aren’t any ETFs marketed as “ESG” in either of these two asset classes.

I say “marketed as,” because there’s at least one real estate ETF that actually uses some socially responsible criteria in its selection process: the $95 million U.S. Diversified Real Estate ETF (PPTY).

Launched by Vident, a firm known for its “principles-based investing” approach, PPTY blends ESG screens with smart-beta indexing by excluding any REIT with “significant governance concerns,” as defined by external management and a low free-float percent. These two indicators, argues Vident, tend to lead to a higher risk of conflicts of interest and misalignment of management and shareholders.

PPTY has an expense ratio of 0.53%, which is only 3 basis points more than the average expense ratio for the real estate sector (0.50%).

For commodities, there aren’t any futures-based ETFs with a socially responsible angle. However, several equity-based ESG ETFs do exist—specifically, renewable energy ETFs. We opted for the SPDR Kensho Clean Power ETF (XKCP), which launched in October and costs 0.45%.

XKCP uses a selection process guided by machine-learning to pick companies involved in renewable energy technology, products and services. As a result, it holds a diversified basket of global renewable energy companies, including biofuels, geothermal, hydroelectric, solar and wind stocks.

Cheaper ESG ETF Portfolios
But let’s say you don’t accept my fudges. PPTY doesn’t count, you say, because ESG isn’t the fund’s primary input for security selection. Or perhaps you believe renewable energy stocks just aren’t the same thing as commodity futures.

If so, we can reroute into cash the 10% of the portfolio that would’ve gone into real estate and commodities. Holding the rest of the allocations unchanged, you end up with an even cheaper portfolio, with a blended expense ratio of just 0.12% (see Figure 2).

Or if instead we use a classic 60/40 split, holding 60% in stocks and 40% in bonds, then our model portfolio’s blended cost drops to 0.13%.

Cost Isn’t Everything
It’s important to remember that the Cheapest ESG ETF Portfolio is one thing and one thing only: cheap. While it’s easy to lose yourself in the hunt for bargains, cost alone can tell you nothing about a fund’s performance, liquidity, volatility, associated risks and so on.

Furthermore, many of the socially responsible funds in this portfolio are less than six months old, meaning they’ve yet to accrue much in the way of assets or track record. As such, they can be illiquid and hard to trade. In fact, only two of the ETFs in our model, ESGV and ESGE, have yet to break the $100 million in AUM liquidity threshold.

Still, it’s important to note there are inexpensive socially responsible options out there, and they keep getting cheaper over time. The same competitive forces driving down costs across the rest of the ETF market are also spurring issuers of ESG ETFs to lower their fees.

While the Cheapest ESG ETF Portfolio may never be as cheap as Matt Hougan’s old model, 0.167% isn’t half bad—especially if this serves as a starting point for fees, and costs only go down from here. Keep in mind that Hougan’s original portfolio, formulated in 2008, had a blended expense ratio of 0.16% before eventually falling to 0.05%.