ETFs have new competition, and its name is ESG.     

Exchange-traded funds have been one of the most disruptive forces in investing in recent years. Burned by decades of high fees and underperformance in actively managed mutual funds, investors have turned to low-cost index ETFs in big numbers. They pulled a net $39 billion from mutual funds and handed $1.5 trillion to ETFs since 2015, according to Bloomberg Intelligence. 

But the ETF industry may soon face a disruption of its own. ESG, which is part of a larger trend known as social investing, is quickly gaining adherents. It was the hot topic at the IMN Global Indexing & ETFs conference I attended recently. As fellow attendee and longtime industry observer Rick Ferri tweeted during the conference, “Many years ago, this conference was all about cap-weighted indices, a few years ago, it was all about Smart Beta. This year, it’s all about ESG.”

For the uninitiated, ESG attempts to identify companies with environmental, social or governance-related policies — thus the acronym — that have historically translated into better-performing stocks. It’s not to be confused with socially responsible investing, or SRI, which attempts to align investors’ portfolios with their values by excluding companies that run afoul of them.

So far, individual investors have turned mostly to ETFs and mutual funds for ESG investing, but that may be about to change. A new generation of online financial advisers buys stocks directly rather than through funds, allowing investors to customize their portfolios. And for social investors, the ability to decide which companies are worthy of their investment dollars is the whole point.

On the surface, ETFs seem like a natural fit for ESG investors. ESG closely resembles other styles of factor investing that have proliferated in the ETF ecosystem, such as value, quality, momentum and low-volatility funds. Both ESG and factor investing attempt to outperform the market by reducing volatility or bolstering returns, or both. Also, they’re both quantitative strategies that use company data to select stocks, which means they can be recast as a rules-based index and tracked cheaply by ETFs.

There’s an important difference between the two, however. There are only so many ways to measure traditional factors such as value. Whatever an investor’s preferred yardstick, there’s likely an ETF that tracks it. ESG, on the other hand, is factor investing on steroids. There are numerous individual factors within each of the environmental, social and governance umbrellas, and each of them can be expressed in myriad ways. Investors are therefore far less likely to find an ETF that captures their preferred approach to ESG. The same is true for other forms of social investing, such as SRI, where no one fund — or even series of funds — can capture the diversity of investors’ values.

That’s probably one reason — in addition to the fact that social investing is littered with impenetrable jargon — investors have shown little enthusiasm for social-investing ETFs, despite the movement’s growing popularity. Of the roughly $4 trillion invested in ETFs, a scant $13 billion is in social investing-related funds.

Matt Moscardi, executive director of ESG Research at MSCI Inc., pointed out in an email that “for investors thinking about ESG, it does make sense to define what ESG is for them, then tailor the portfolio.” Many institutional investors are doing just that. MSCI boasts 1,300 institutional investors from around the world that use its ESG ratings and research, a monster trove covering 650,000 securities and 8 million derivatives globally. 

Unlike institutions, it’s not practical for individual investors to build their own ESG portfolios. The cost of the data is prohibitive relative to the size of most individual portfolios. And even if it were affordable, most investors don’t have the time or expertise to comb through the vast quantity of ESG data. This is where the new breed of online advisors comes in. Upstarts such as Open Invest Co. and Ethic Inc. are removing those barriers and allowing investors to customize their portfolios around their social investing priorities.

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