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.
A key takeaway is that, in addition to considering fundamental criteria such as cost and portfolio turnover/tax-efficiency, investors—and their advisors—need to take the time to “look under the hood” and understand the rules governing the underlying index that each fund tracks, to ensure that the fund’s goals are aligned with theirs.
Even broad-based funds have some important differences in the criteria they use to include and exclude securities. Furthermore, ESG selection criteria can result in particular industry sector biases, with consequent potential risks.
Among domestic funds, four ETFs met our search criteria.
The two ETFs that have the broadest ESG screens also happen to be the oldest and largest ETFs in this category: The first is the iShares MSCI KLD 400 Social ETF (DSI).
Launched by Barclays (BlackRock iShares’ predecessor) in 2006, DSI tracks the first and perhaps most well-known ESG index in the U.S., formerly known as the Domini 400 Social Index—a float-adjusted, market-cap-weighted index with screens based on a comprehensive range of ESG criteria.
As of this writing, it excludes some well-known names, including Apple (currently the largest company in the U.S. by market capitalization), and is relatively overweight in technology stocks and underweight in financial stocks compared to the broad U.S. market.
Interestingly, before DSI, an open-end mutual fund now known as the Domini Social Equity Fund (DSEFX) tracked this index. However, DSEFX transitioned to an active strategy at the time DSI was launched, and concurrently increased its gross annual operating expense ratio, which is presently 1.16%.
By contrast, DSI, the index tracker, carries a 0.50% annual expense ratio. The fund has almost $748 million under management and 400 holdings, and its trading volume, as of this writing, is roughly 35,000 shares.
This second iShares ESG ETF, KLD, originally tracked a condensed (“select”) version of the Domini 400 Social Index, and in 2010, switched to an entirely new index independent of the Domini 400.
It is designed to exhibit risk and return characteristics similar to those of the unscreened MSCI USA Index. As such, the fund caps sector deviation from this broader benchmark at 3%. Even so, both KLD and DSI currently exhibit similar industry sector weightings. KLD has fewer holdings than DSI (about 115 versus roughly 400) and thus a slightly higher concentration in terms of its largest holdings (including, interestingly, Apple).
Like DSI, KLD carries an annual expense ratio of 0.50%. However, investors should note that it is a smaller fund than DSI, with slightly more than $475 million under management, and trades with a lower average volume of about 17,000.
The other two ETFs that met our search criteria are newer and have narrower ESG objectives:
This relative newcomer was launched in November 2015 and currently has just over $235 million in net assets. SPYX was developed with the support of the Natural Resources Defense Council (NRDC) to meet the needs of climate-conscious investors.
NRDC is a cornerstone investor in the fund, which aims to create an effective vehicle to invest in S&P 500 companies that do not own fossil fuel reserves. The S&P 500 Index serves as the fund’s initial universe of eligible securities, which is then screened to exclude companies with any ownership of fossil fuel reserves, including for third-party and in-house power generation. The index is weighted by float-adjusted market capitalization.
At this point, SPYX purchases a representative sampling—rather than all—of the companies in the underlying index. It currently has approximately 480 holdings. As one would expect, SPYX is underweighted in the energy sector relative to the S&P 500; conversely, it is overweight in technology and health care. SPYX, with $114 million in assets, has a gross expense ratio of 0.25%, and average trading volume of about 12,100.
Launched in March 2016, this fund tracks State Street’s proprietary SSGA Gender Diversity Index, which is designed to invest in U.S. large-cap companies that are “gender diverse,” meaning companies that exhibit gender diversity in their senior leadership positions.
The California State Teachers’ Retirement System seeded this ETF with an initial $250 million investment and it has more than $290 million in assets. The fund seeks to minimize divergence from the sector weighting of the 1,000 largest listed U.S. companies. Given the current composition of executive boardrooms, however, it is significantly underweight in the technology sector and overweight in health care.
Currently, there are approximately 185 holdings. It has a 0.20% gross expense ratio, with average trading volume of about 29,000.
As with any ETF, investors should be mindful of costs other than expense ratios, including brokerage commissions and bid/ask spreads. Indeed, bid/ask spreads are particularly relevant in the case of the four ETFs just described, because they trade with relatively light volume.
ETFs are also bought and sold at market prices, which can differ from underlying net asset values (NAVs). However, these four ETFs comprise comparatively large, liquid stocks, and not surprisingly, all traded within 0.50% of their NAV for the quarter ending Sept. 30, 2016.
While more international ESG index/passive options have become available over the past several years, just one ETF currently meets this survey’s criteria.
This fund, initially created for the United Nations Joint Staff Pension Fund, is more global than international. It tracks the MSCI ACWI Global Low Carbon Target Index, which seeks a lower carbon exposure than that of the broad market by overweighting companies with low carbon emissions (relative to sales) and with low potential carbon emissions (per dollar of market capitalization).
The index includes large-cap and midcap stocks across 23 developed markets and 23 emerging markets, and it includes U.S. companies, which currently represent about 50% of the portfolio. CRBN traded within ± 0.50% of its NAV 91% of the time during the quarter ending Sept. 30 (versus 100% of the time for the domestic ETFs listed above).
As with all international ETFs, this may be due in part to the difference in closing times for domestic and international markets. CRBN has a 0.20% expense ratio and about $320 million under management.
Several new broad-based ETFs are currently in registration with the SEC, from established asset managers such as BlackRock and Goldman Sachs, and Nuveen (now a subsidiary of TIAA), launched five new such ETFs last week.
Each of the major indexing groups—namely FTSE Russell, MSCI and S&P Dow Jones—has comprehensive suites of ESG indexes, presenting a wide array of licensing opportunities for potential new funds.
Although it is encouraging to see more alternatives become available, some noticeable asset class gaps remain to be filled with funds that are relatively low-cost and that have garnered sufficient asset heft to ensure a decent probability of staying power.
That said, should the current growth trajectory of ESG investing continue, these gaps hopefully should be filled over time, making it even easier to incorporate one’s values into a broadly diversified cost- and tax-efficient asset allocation plan.
Lorne Abramson, CFA, CFP is a principal and co-founder of ELM Advisors, a portfolio and wealth management firm located in Burlingame, California. Elana Lieberman is a principal and co-founder of ELM Advisors.