World's Cheapest ESG ETF Portfolio

May 16, 2018

Once upon a time, former ETF.com CEO Matt Hougan would write 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 (read: "World's Lowest Cost Portfolio Hits 0.05% Fee").

His portfolio wasn't an investable model as much as a metric: a quick-and-dirty gauge of the lowest costs across the overall ETF industry.

What he found is that some sectors tend to be more expensive than others. That goes double for "socially responsible" or environmental, social and governance (ESG) investments, which can be significantly more expensive than their vanilla counterparts.

This may be changing, however. For example, BlackRock recently slashed expense ratios for the two largest ETFs in the ESG space, the $1.1 billion iShares MSCI KLD 400 Social ETF (DSI) and the $704 million iShares MSCI U.S.A. ESG Select ETF (SUSA).

That's why I decided to crib Matt's idea and apply it to the ESG space. Was it even possible, I wondered, to build a broadly diversified portfolio using only socially responsible ETFs? If so, would it end up costing an arm and a leg?

The answer is, yes, I could (mostly) replicate Matt's model, using only ESG ETFs. What I found more surprising, however, was that the whole thing cost just 0.21%.

Building An All-ESG ETF Portfolio

To build 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 its benchmark, liquidity, assets under management or even its trading costs. The only thing that mattered was its sticker price.

The resultant portfolio, which provides exposure to 1,058 stocks from 46 countries, as well as 174 bonds, has a blended expense ratio of 0.21%. That's less than half the cost of the average equity ETF (0.54%):

 

World’s Cheapest ESG ETF Portfolio
Asset Class Weight Fund Ticker Expense Ratio
U.S. Equity 40% iShares MSCI U.S.A. ESG Optimized ETF ESGU 0.15%
Developed Markets Equity 30% iShares MSCI EAFE ESG Optimized ETF ESGD 0.20%
Emerging Markets Equity 5% iShares MSCI EM ESG Optimized ETF ESGE 0.25%
Fixed Income 15% NuShares ESG U.S. Aggregate Bond ETF NUBD 0.20%
REITs 5% U.S. Diversified Real Estate ETF PPTY 0.53%
Commodities 5% iShares Global Clean Energy ETF ICLN 0.48%
         
    Blended Expense Ratio   0.21%

Source: ETF.com; data as of May 10, 2018

 

iShares Leads In Low-Cost ESG

My portfolio gets its 75% equity allocation from three iShares "ESG Optimized" ETFs. These funds—the iShares MSCI U.S.A. ESG Optimized ETF (ESGU), the iShares MSCI EAFE ESG Optimized ETF (ESGD) and the iShares MSCI EM ESG Optimized ETF (ESGE)—aim to replicate the performance of well-known MSCI benchmarks, like the MSCI EAFE Index and the MSCI Emerging Markets Index, while at the same time culling those benchmarks to enhance their ESG potential.

Securities for inclusion in ESGU, ESGD and ESGE are first ranked based on various environmental, social and governance risk factors: a company's carbon emissions or water usage, for example, or its labor practices and corruption scandals. Then portfolio optimization software is used to organize highly rated companies into a blend that will provide marketlike exposure, performance and risk.

These three ETFs also completely screen out tobacco stocks, controversial weapons makers, and civilian firearms producers and retailers, as well as companies experiencing "severe business controversies."

Intriguingly, ESGD and ESGE are significantly cheaper than the vanilla ETFs tracking the same benchmarks: the iShares MSCI EAFE ETF (EFA), for example, costs 0.32%, while the iShares MSCI Emerging Markets ETF (EEM) costs 0.69%. iShares actually has cheaper versions of these two vanilla funds, but their underlying MSCI indexes have slightly different parameters in terms of coverage.

Nuveen: Cheapest ESG By Default

Another 15% of the portfolio is in fixed income. Currently, there's only one broad-market U.S. bond ESG ETF available, however: the NuShares ESG U.S. Aggregate Bond ETF (NUBD). (Other ETFs exist that drill down into specific sectors within the U.S. bond market.)

NUBD offers an ESG twist on the Bloomberg Barclays US Aggregate Bond Index (aka "the Agg"), which comprises Treasuries, investment-grade credit, agency debt, MBS and more. Using MSCI's ESG ranking system, NUBD screens for highly ranked bonds, then market-value-weights them among the various fixed-income sectors. These sectors follow the same weights as the Agg.

NUBD has an expense ratio of 0.20%, which is four times that of the iShares Core U.S. Aggregate Bond ETF (AGG), the non-ESG version that tracks the same index.

 

Few ESG Options For Real Estate

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 is at least one real estate ETF that actually uses some ESG criteria in its selection process: the 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 three basis points more than the average expense ratio for the real estate sector (0.50%).

ESG In Commodity Equities

For commodities, there aren't any futures-based ETFs with an ESG angle. There are, however, several equity-based ESG ETFs—specifically, renewable energy ETFs.

The cheapest and broadest, the iShares Global Clean Energy ETF (ICLN), holds a diversified basket of global renewable energy companies, including biofuels, geothermal, hydroelectric, solar and wind stocks.

ICLN has an expense ratio of 0.48%, which is significantly cheaper than the average vanilla energy ETF (0.73%).

Getting Even Cheaper With ESG

But let's say you don't accept my fudges. PPTY doesn't count, you say, because ESG isn't the primary input for security selection; renewable energy stocks just aren't the same thing as commodity futures; and we should stick to as pure a definition of ESG as possible.

So let's put the 10% of the portfolio that would have gone into real estate and commodities into cash. Holding the rest of the allocations unchanged, you end up with a blended expense ratio of the full portfolio of 0.16%.

Or if we instead revert to a classic 60/40 portfolio, with 60% in stocks and 40% in bonds—to keep things simple, let's split that 60% stock allocation into 30% U.S. stocks, 20% developed-market stocks and 10% emerging market equities—the portfolio's blended expense ratio drops to 0.19%:

 

World’s Cheapest ESG ETF Portfolio (60/40 version)
Asset Class Weight Fund Ticker Expense Ratio
U.S. Equity 30% iShares MSCI U.S.A. ESG Optimized ETF ESGU 0.15%
Developed Markets Equity 20% iShares MSCI EAFE ESG Optimized ETF ESGD 0.20%
Emerging Markets Equity 10% iShares MSCI EM ESG Optimized ETF ESGE 0.25%
Fixed Income 40% NuShares ESG U.S. Aggregate Bond ETF NUBD 0.20%
         
    Blended Expense Ratio   0.19%

Source: ETF.com; data as of May 10, 2018

 

Starting Point

Like I said at the start, the World's Cheapest ESG ETF Portfolio is only that: cheap. Cost tells you nothing about how a fund performs, how liquid it is, how volatile, what risks it exposes you to and so on.

Still, it's important to note there are inexpensive ESG 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 World's Cheapest ESG ETF Portfolio may never be as cheap as Matt's old model, 0.21% isn't half bad—especially if this serves as just the starting point for fees, and it only goes down from here.  

Contact Lara Crigger at [email protected]

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