Q&A: How to Build Better Portfolios With ESG ETFs

There has recently been a groundswell of interest in ESG products, or those that focus on environmental, social and governance factors.

ESG funds had $21.5 billion in inflows in the first quarter of 2021, setting a new record, according to Morningstar. A large part of this growing interest is due to research showing ESG investing doesn’t mean giving up returns. Instead, sustainable equity funds “significantly outperformed” their traditional peers in 2020, Morningstar reports. Additionally, three out of four sustainable funds were in the top half of their category group’s performance, with 42% in the top quartile, while only 6% landed in the bottom quartile.

Younger investors, who are poised to take control of more than $30 trillion in the next few decades in a wealth transfer from baby boomers, are particularly interested in ESG investing. Nearly 9 in 10 wealthy millennials told MSCI in a 2020 report that they actively consider the ESG impact of their portfolios, and more than half say they’ve chosen not to invest in a company because of its negative social impact.

Numbers like this suggest the rise in ESG interest is only going to continue, which means financial advisors need to be prepared to help clients build ESG portfolios. We spoke with Arne Noack, head of systematic investment solutions at DWS Group, a global asset manager on the forefront of ESG research and implementation.

Noack shares his tips for how advisors can construct ESG portfolios and what to watch out for when choosing funds. Here are edited excerpts from that interview.

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What should financial advisors be aware of when adding ESG funds to client portfolios?

It’s important to note that not all ESG funds are made the same. It’s imperative that advisors and investors do their due diligence to avoid green-washed funds (which make misleading claims about their sustainability to capitalize on the ESG trend) and effectively discern which investments best support their long-term investment goals and values. Some considerations to look for include a company’s environmental policies and procedures and carbon intensity, plus whether a company benefits from a diverse workforce and board of directors or is involved in any controversies.

It’s also important to be mindful of the construction process of the ESG exchange-traded fund, as some may lead to a higher than desired tracking error to the non-ESG benchmark index and, subsequently, impact the relative performance. To account for that, advisors may consider looking at ETFs that take a sector- or industry-group-neutral ESG approach by screening out companies that score lowest in terms of ESG in their respective sector or industry group, while maintaining leading companies in the fund.

Some ETFs take this approach and are constructed such that they contain a limited tracking error risk versus their non-ESG equivalent benchmark index — for example the S&P 500 — while meaningfully improving the ESG-related scores of the portfolio.

Can you walk us through the process advisors should take when evaluating ESG ETFs for portfolios?

First, advisors and investors should determine the overall composition of their desired portfolio allocations. For example, how much of the portfolio should be dedicated to U.S. large-cap stocks? How much should be diversified with emerging market or high-yield bond exposure? Then they can choose an ESG ETF to fit their needs.

When selecting the individual product, advisors and investors can use the usual features to evaluate ETFs, such as total expense ratio, assets under management, secondary market liquidity, et cetera. In addition to these standard metrics, ESG ETFs may provide additional reporting to investors, like exposure to ESG leading companies or details for the reduction of the carbon footprint of the companies included in the portfolio versus a given benchmark index.

Finally, be mindful of proxy voting. How asset managers vote at annual general meetings of the underlying companies can be important for ESG-related issues. For example, while two ETFs could track the same index, the underlying proxy voting records of their managers could look quite different and may greatly influence the net ESG impact of each fund.

[READ: Q&A: An ETF for Investors With FOMO.]

How will the focus of President Joe Biden’s administration on climate policy influence ESG?

The U.S.’s response to climate change will be an important focus of the Biden administration. Underscoring this commitment, on his first day in office, he recommitted the U.S. to the Paris Climate Agreement and has set an ambitious greenhouse gas emissions target for the U.S. that will seek to cut emissions by 50% before 2030.

An early indication of the implications for the financial and corporate world may be the Securities and Exchange Commission’s plan to make corporate climate change disclosures mandatory. It will require companies to disclose their (audited) carbon footprint as well as report on how to reach climate goals.

Having said that, we see the importance of ESG conscious investing increasing both globally and in the U.S. As investors and providers of investment solutions, we need to help ensure required capital allocations can be made effectively and transparently to companies and institutions, which may be well positioned to address some of the most pressing topics of our age.

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Q&A: How to Build Better Portfolios With ESG ETFs originally appeared on usnews.com

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