This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Lorne Abramson, principal and co-founder of ELM Advisors, based in Burlingame, California. Elana Lieberman, principal and co-founder of ELM, contributed to this report.
Environment, sustainability and governance (ESG) investing—often referred to as ethical, socially responsible or impact investing—continues to experience significant growth and momentum. Over the past five years, ESG fund assets have jumped 76% to $201.3 billion, according to Morningstar data through September 2016.
Fortunately for ESG investors who take an index/passive asset class approach, a growing number of cost- and tax-efficient vehicles continue to be launched, particularly exchange-traded funds.
Of course, ESG screens—which often rely on an added layer of internal or third-party research services—can result in somewhat higher embedded fund expenses compared with their nonscreened alternatives. However, it is getting easier for index-oriented investors to build well-diversified ESG portfolios at a reasonable cost.
Here we examine the broad-based secular ESG index/passive ETFs currently available to investors. We don’t cover narrower ESG-related index vehicles focusing on specific niches such as clean energy, nor do we look at funds explicitly intended for faith-based investors.
Moreover, we discuss only stock funds. Indeed, there remains a dearth of relatively low-cost ESG fixed-income funds.
Focus On ‘Overlay’ Component
Our focus here is on ESG as an “overlay” component, building upon the fundamental principles of global asset class diversification, cost minimization and tax-efficiency. More specifically, this survey views ESG as being complementary to investing in existing, traditional asset classes, rather than being its own distinct asset class.
To identify the funds, we used Morningstar’s research database on U.S.-based open-end ETFs, with the following search criteria (all data are as of Sept. 30, 2016, unless noted otherwise):
- First, identify funds categorized as “socially conscious” by Morningstar. Although Morningstar recently applied a new “sustainability rating” to upward of 20,000 funds in its coverage universe, we examined only funds that have an explicit ESG mandate as part of their investment objective.
- Then filter this list to include only those funds that have:
- A gross expense ratio of 0.50% or lower. While there are ESG index funds with gross expense ratios higher than this threshold, one of the primary attributors of index funds’ superior performance over time, relative to most actively managed funds, is their lower ongoing costs. Moreover, we used gross expense ratios rather than net expense ratios to account for any current fee waivers that may be only temporary. Finally, we used the gross expense ratio threshold as a proxy to identify both index and passive asset class funds—as a search for ESG funds labeled by Morningstar as “index funds” may have overlooked low-cost, passive asset class funds that do not necessarily track indexes (such as Dimensional Fund Advisors’ ESG funds).
- Assets of $100 million or greater. The intent here was to identify those funds that have a higher chance of surviving over time. This is particularly relevant for funds held in taxable portfolios, as significant unintended capital gains distributions can occur from fund closures and liquidations.