Building A Socially Responsible Smart Beta ETF

Two recent investment trends converge in the ETF wrapper.

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Reviewed by: Luis Guerra
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Edited by: Luis Guerra

During the past few months, a new suite of ETFs has emerged combining two popular themes: socially responsible investing and smart-beta factors.

These ETFs aim to achieve their dual mandate by selecting stocks based on a principle-based methodology, then applying further screens to match the ETF portfolio to a factor or multifactor investment style.

ETF issuers and index providers expect advisors to use these funds to implement strategic and tactical portfolio decisions while keeping their clients’ social concerns in mind. While these products have complex rules and methodologies, a quick overview on how these ETFs are built can help us understand this new and innovative niche in the ETF market.

Size & Style Definition

As of March 2017, there are 11 socially responsible smart-beta ETFs in U.S. markets. Their rigorous selection process starts by delimiting the investment universe of eligible securities. This crucial step sets up the initial constraints and characteristics of the ETF.

For example, as seen in the table below, the Oppenheimer ESG Revenue ETF (ESGL) selects its stocks exclusively from the S&P 500 Index, meaning that ESGL will only target large-cap U.S stocks. By limiting the universe of securities, the index provider can focus its attention on the particular market size and style it wants to apply to its ESG screens and factor methodology. 

Underlying Indices & Investment Universe (by AUM)

TickerFundUnderlying IndexInvestment Universe
ESGLOppenheimer ESG Revenue ETFOFI Revenue Weighted ESG IndexS&P500 Index
ESGFOppenheimer Global ESG Revenue ETFOFI Revenue Weighted Global ESG IndexMSCI All Country World Index
ISMDInspire Small/Mid Cap Impact ETFInspire Small/Mid Cap Impact Equal Weight IndexS&P Midcap 400 Index and Russell 2000 Index
NUSCNuShares ESG Small-Cap ETFTIAA ESG USA Small-Cap IndexMSCI USA Small Cap Index
ESGNColumbia Sustainable International Equity Income ETFBeta Advantage Sustainable International Equity Income 100 IndexMSCI World ex USA Index
NULGNuShares ESG Large-Cap Growth ETFTIAA ESG USA Large-Cap Growth IndexMSCI USA Growth Index
NUMGNuShares ESG Mid-Cap Growth ETFTIAA ESG USA Mid-Cap Growth IndexMSCI USA Mid-Cap Growth Index
NULVNuShares ESG Large-Cap Value ETFTIAA ESG USA Large-Cap Value IndexMSCI USA Value Index
NUMVNuShares ESG Mid-Cap Value ETFTIAA ESG USA Mid-Cap Value IndexMSCI USA Mid-Cap Value Index
ESGSColumbia Sustainable U.S. Equity Income ETFBeta dvantage Sustainable U.S. Equity Income 100 IndexMSCI USA Index
ESGWColumbia Sustainable Global Equity Income ETFBeta Advantage Sustainable Global Equity Income 200 IndexMSCI World Index

 

Socially Responsible Screens

In the next step of the selection process, the index provider screens the stocks included in the investment universe, and selects those that adhere to its respective principle-based criteria. You can see the ESG method criteria used by these funds in the table below:

 

ESG Methodology & Ranking Criteria (by AUM)

TickerFundESG MethodologyESG Ranking Criteria
ESGLOppenheimer ESG Revenue ETFSustainalytics  ESG ScoringTop 50% categories
ESGFOppenheimer Global ESG Revenue ETFMSCI ESG Research RatingsTop 50% rank
ISMDInspire Small/Mid Cap Impact ETFInspire Impact ScoreBiblical Values and positive impact
NUSCNuShares ESG Small-Cap ETFTIAA ESG Methodology ESG Leaders and Carbon Emissions Screens
ESGNColumbia Sustainable International Equity Income ETFMSCI ESG IVA MethodologieNo lower than BB
NULGNuShares ESG Large-Cap Growth ETFTIAA ESG Methodology ESG Leaders and Carbon Emissions Screens
NUMGNuShares ESG Mid-Cap Growth ETFTIAA ESG Methodology ESG Leaders and Carbon Emissions Screens
NULVNuShares ESG Large-Cap Value ETFTIAA ESG Methodology ESG Leaders and Carbon Emissions Screens
NUMVNuShares ESG Mid-Cap Value ETFTIAA ESG Methodology ESG Leaders and Carbon Emissions Screens
ESGSColumbia Sustainable U.S. Equity Income ETFMSCI ESG IVA MethodologyNo lower than BB
ESGWColumbia Sustainable Global Equity Income ETFMSCI ESG IVA MethodologyNo lower than BB

 

Most of these funds use a proprietary ESG ratings. Usually, these methodologies rank companies based on how well each company manages its environmental, social and corporate governance (ESG) practices.

For example, MSCI’s model makes adjustments depending on each industry ESG risk exposure and how well a company’s management mitigates or takes advantage of each ESG risk:

  • Environmental risks include themes such as carbon emissions, natural resources usage, pollution and waste management.
  • Social risks consist of themes around labor health, safety and human capital development, product life liability, and stakeholders conduct.
  • Corporate governance risks embody themes such as board structure, pay, business ethics and transparency.

Principle Value Screening

Some indexes also exclude companies from their investment universe to better align their products to their principle values.

As an example, the Inspire Small/Mid Cap Impact ETF (ISMD) aims to select companies associated with biblical values, thus excluding companies with any degree of participation in abortion, gambling, alcohol, pornography, LGBT lifestyle, or doing business in terrorist-sponsoring countries.

In other cases, such as NuShares’ funds, their indexes exclude any company that owns fossil fuel reserves, as part of their carbon-screening criteria.

 

Adding Smart-Beta Factors To Mix

What sets these funds apart from other socially responsible ETFs is the inclusion of smart-beta factors. These factors, as developed by Eugene Fama and Kenneth French, are the key drivers of equity risks and returns.

Advisors can take advantage of these factors to tilt a portfolio according to the risk tolerance of their clients or to outperform a market portfolio.

Index providers achieve exposure to these factors by either screening stocks or modifying the weight of the securities in an ETF portfolio based on a particular fundamental factor. The table below lists the different factors used by these ETFs:

Smart-Beta Factor (by AUM)

TickerFundSmart-Beta Factor
ESGLOppenheimer ESG Revenue ETFSales
ESGFOppenheimer Global ESG Revenue ETFSales
ISMDInspire Small/Mid Cap Impact ETFSize: Small Cap tilts
NUSCNuShares ESG Small-Cap ETFSize: Small Cap tilts
ESGNColumbia Sustainable International Equity Income ETFDividend
NULGNuShares ESG Large-Cap Growth ETFGrowth
NUMGNuShares ESG Mid-Cap Growth ETFGrowth
NULVNuShares ESG Large-Cap Value ETFValue
NUMVNuShares ESG Mid-Cap Value ETFValue
ESGSColumbia Sustainable U.S. Equity Income ETFDividend
ESGWColumbia Sustainable Global Equity Income ETFDividend

 

NuShares funds obtained factor exposure by using a predefined investment universe of stocks geared toward a factor.

Oppenheimer funds instead use a proprietary revenue weighting to outperform its benchmark.

Columbia funds use a proprietary factor ESG alongside dividend yield to seek income opportunities. An equal-weighting scheme is also used in ISMD to tilt the ETF portfolio to small-cap stocks to benefit from the company size factor.

New ETF Marketplace Niche

By adopting smart-beta traits into ESG products, ETF issuers are betting on a growing demand for socially responsible products.

Still, these ETFs are young, and have only just begun to gather assets, and fund closure risks are latent. Nonetheless, this is an exciting new idea in the ETF marketplace, and if these products prove successful, expect socially responsible investing to enter other areas of the ETF space, such as international ETFs or fixed-income ETFs.

At the time of writing, the author did not own any of the securities mentioned. Luis Guerra can be reach at [email protected].

 

Luis Guerra, CFA, is the Product Manager of etf.com. He develops new features and functionalities for the website. Guerra also manages and maintains the etf.com database. He graduated with honors from Barry University with a dual degree in finance and international business.