Building A Socially Responsible Smart Beta ETF

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)

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)

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)

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].