Sustainable, responsible and impact investing (SRI) strategies are a growing corner of the investment universe. According to one study, total U.S.-domiciled assets under management using these methods nearly doubled from $3.74 trillion in 2012 to $6.57 trillion in 2014. That means $1 out of every $6 of assets under management in the United States is dedicated to some type of sustainable investment strategy.
While the trend is strong among pension funds and other institutional investors, it hasn’t caught fire in the world of exchange-traded funds. There are only 23 “principles-based” ETFs with a total of $1.9 billion in assets, according to ETF.com., and they represent well under 1% of the total ETF universe. Ten of them were launched just this year.
One reason for this is the widely held view that adding a set of investment constraints leads to poorer returns. When clients ask about sustainable investing, financial advisors often recommend that they stick with traditional investments and satisfy philanthropic leanings by donating to charity.
But the stigma of underperformance may be fading as the definition of sustainable investing expands. Years ago, most screening methods for investors who wanted to add principles to their portfolios focused on weeding out “sin stocks” in industries such as alcohol, defense or tobacco, creating a bias toward technology and smaller companies. By contrast, today’s more common environmental, social and governance (ESG) screening methods yield a more balanced group of companies in diverse sectors that accommodate a wider range of portfolio holdings.
“Empirical results show ESG investing not only lives up to the performance of conventional fund benchmarks, but that it has the potential to outperform them,” said Rolf Kelly, a portfolio manager of the Thornburg Better World International Fund (TBWCX), in a recent study.
It appears the budding relationship between ETFs and ESG will likely blossom over time. Earlier this year, Morningstar introduced sustainability ratings for mutual funds and ETFs, complete with a catchy pictorial format that rates investments on a scale of one to five globes.
Elsewhere, pension funds and other institutional money managers are getting into the act. One notable example occurred last March, when the California State Teachers’ Retirement System (CalSTRS) partnered with State Street Global Advisors to launch the SPDR SSGA Gender Diversity Index ETF (SHE). CalSTRS got the ball rolling with a $250 million initial investment, and a portion of the revenue the ETF generates will go toward a charitable trust dedicated to promoting female participation in “STEM” fields (science, technology, engineering and mathematics).
Time To Get On Board?
For some advisors, adopting sustainable investing in portfolios is more about appeasing client preferences than a desire to make the world a better place. According to a survey done in 2015 by the Morgan Stanley Institute for Sustainable Investing, 84% of millennials (those born between 1980 and 2002) indicated an interest in sustainable investing. The indexed nature of ESG investments makes them especially appealing to younger investors, who favor the ETF format more than other demographic groups.
A 2016 survey by U.S. Trust reveals that interest in impact investing is increasing, especially among high-net-worth women, millennials, Gen Xers and those with at least $10 million in investable assets. The majority of these segments believe the social, political or environmental impact of investments is an important factor when choosing funds.
A few of the ESG-focused ETFs are closing in on five- or 10-year track records, which makes long-term performance easy to compare with traditional benchmarks. Take for example, the iShares MSCI KLD 400 Social ETF (DSI), which rose 57% from its first full year of operation beginning in January 2007 through late September while the S&P 500 rose 53% during the same period. The fund has garnered over $628 million in assets.
Over the past five years, the DSI fund’s annualized return of 15.4% fell a bit below the SPDR S&P 500 (SPY) return of 16.2%. Meanwhile, another broad-based, ESG-focused product, the iShares MSCI USA ESG Select ETF (KLD), generated annualized returns of 14.3% during that time frame. Both of these ESG funds have to fight against a headwind of 0.50% net expense ratios, when the SPDR fund’s is only 0.09%. In addition, their distribution yields—both in the 1.5% range—are roughly 50 basis points less than the SPY fund’s.
As with any ETF, differences in index construction affect performance. In an article titled “Unintended Biases in ESG Index Funds,” Morningstar analyst Alex Bryan notes that the underlying index for the mutual fund Vanguard FTSE Social Index Fund (VFTSX) has considerably more exposure to financial services and health-care stocks than either of the iShares ETFs, and less to consumer defensive, communication services and energy. The Vanguard fund is also more volatile and more sensitive to the market than the ETFs, and has a slightly greater value tilt because of its large overweighting in financial services stocks.