Two of the biggest trends in investing these days are the popularity of one-fund portfolios and the focus on sustainability. A new family of iShares ETFs has combined these two key trends in a way that allows Canadians to build socially responsible portfolios with a single trade.
One of the major obstacles to ESG investing (the acronym stands for “environmental, social and governance”) is that it can be difficult to build and maintain a globally diversified portfolio. There’s a long list of ETF choices, and making an informed decision requires a lot of research, since the methodologies are very different. And even after you’ve made your choices, you’ll wind up juggling a lot of moving parts.
The new iShares ETFs are designed to solve these problems. They’re modeled after iShares “Core” asset allocation ETFs, which include the popular XBAL and XGRO, and there are four flavours to choose from, ranging from 40% to 100% stocks.
|iShares ESG Conservative Balanced ETF Portfolio||GCNS||40%||60%|
|iShares ESG Balanced ETF Portfolio||GBAL||60%||40%|
|iShares ESG Growth ETF Portfolio||GGRO||80%||20%|
|iShares ESG Equity ETF Portfolio||GEQT||100%||0%|
The new ESG portfolios have a management fee of 0.22%, which is 0.04% higher than the Core asset allocation ETFs. But if you’re committed to socially responsible investing, chances are you won’t mind paying an extra few basis points for a well-designed ESG portfolio.
How are the stocks selected?
Each of the iShares ESG portfolios includes three underlying equity ETFs: one each for Canadian, US, and international companies. These three ETFs follow a family of benchmarks known as the MSCI Choice ESG Screened Indexes.
The indexes start with the broad universe of stocks and then apply a series of screens, or filters, that remove companies with poor ratings on environmental, social and governance issues. They exclude companies that have been involved in controversies (toxic spills, human rights violations, corrupt directors), and those whose business activities include nuclear weapons, civilian firearms, adult entertainment, alcohol, tobacco, gambling, for-profit prisons, predatory lending, and others.
It’s worth spending some time understanding the methodology, because it might not correspond to your own values. We can all agree that landmines and oil spills are terrible things, but you might not put vodka coolers and Chardonnay in the same category. The MSCI indexes also exclude companies involved in nuclear power and genetically modified organism (GMOs), two issues that environmentalists don’t always agree on.
What if you’re looking to exclude fossil fuels? The MSCI Choice ESG Screened indexes don’t automatically do this: they may include a company if it derives at least half its revenue from renewable energy or alternative fuels. However, in practice, the MSCI methodology has been very effective at removing fossil fuels. For example, about 11% of the broad Canadian market is in the energy sector, while the MSCI Choice ESG benchmark for Canada includes no energy companies whatsoever.
Overall, you can expect lower allocations to the utilities and healthcare sectors, and correspondingly more weight to financials and technology.
There’s one more significant change to be aware of: the ESG portfolios completely exclude emerging markets, which make up 5% of the equity component in the iShares Core asset allocation ETFs. To compensate, the ESG portfolios include an additional 5% in Canadian stocks, so the overall mix is 30% Canadian, 45% US, and 25% international developed equities.
What about bonds?
Now let’s look at the fixed income side of the iShares ESG portfolios.
A traditional broad-market bond index fund includes about two-thirds in government bonds and about one-third in corporates. The iShares ESG portfolios, by contrast, allocate 100% of the fixed income to government bonds, with a focus on those with the highest credit ratings.
They get this exposure through two ETFs that hold ladders of Canadian government bonds: the iShares 1-5 Year Laddered Government Bond Index ETF (CLF) makes up 60% of each portfolio’s fixed income allocation, while another 30% goes to the iShares 1-10 Year Laddered Government Bond Index ETF (CLG). The final 10% goes to the US-listed iShares 20+ Year Treasury Bond ETF (TLT).
Overall, the bonds in the ESG portfolios have a shorter average maturity and a lower duration than those in the Core asset allocation ETFs. That means they should be less volatile, but investors should also expect correspondingly lower returns compared with a portfolio that includes corporate bonds and bonds with longer maturities.
Can you expect higher returns?
Now let’s consider whether the new iShares ESG asset allocation ETFs can be expected to deliver similar performance to the more traditional Core portfolios. Will excluding so many companies cause these funds to deliver dramatically different returns from the broad market?
Of course, we can never predict future performance, and unfortunately even the backtested data on the MSCI Choice ESG Screened Indexes only goes back to June 2013. But for what it’s worth, the ESG indexes have outperformed the more traditional Core indexes since that time. Not surprisingly, that outperformance was particularly strong on the equity side, so the more aggressive the portfolio, the greater the outperformance:
|Risk Level||iShares ESG Portfolio (Annualized)||iShares Core Portfolio (Annualized)||Average Outperformance (Annualized)|
Source: BlackRock, for the period May 31, 2013 through September 30, 2020
What’s the reason for this significant outperformance? The explanation is simple: as we’ve noted, the ESG equity indexes overweight technology stocks and underweight energy. And over the last seven-plus years, the former sector has been a huge winner. Canadian tech stocks had an annualized return of 25.6%, while Canadian energy stocks had an annualized loss of 14.2%. That’s a difference of almost 40% annually. Clearly, not every period is going to see these two sectors diverge so sharply, so don’t expect the same kind of outperformance over longer periods.
But my guess is that trouncing the market isn’t what most people expect when looking for ESG investments. It’s more likely you want returns similar to the broad market, while eliminating the irresponsible companies that cause harm to the environment and your fellow citizens. And you want to do this with a well diversified portfolio that won’t require you to pick individual stocks or do extensive research on your own. If that’s your goal, and you’re comfortable with the methodology, then the iShares asset allocation ETFs seem ideal.
Just remember that any time you waver from a traditional indexing strategy, you’ll need to be comfortable with the possibility of underperforming the broad market. This will certainly occur over short periods, and it could happen over the very long term as well. So you’ll need to be prepared to stick with the strategy even when it feels like it’s not working.
From a personal point of view, an argument for adopting a ESG portfolio is it screens out companies with irresponsible and controversial practices likely to result in problems down the road like disaster liabilities, bankruptcies, etc which will affect share value.
From a societal point of view, the big question is, if many investors flock to these ESG index funds, will it have an effect, encouraging companies to improve and maintain their practices so they qualify to be included? Is there an incentive for them to do so? Does it hurt the “unethical” industries not to be included? Is this an effective way for investors to help drive the change they would like to see in the world?
Were you aware of the new Tangerine ETF portfolios? They seem like a step in the right direction for cost effieciency, but they don’t seem to have a precise rebalance strategy.
@Anon: The information on these brand-new funds is pretty sparse: I’ve reached out to Tangerine for more info. The first point to clarify is that these are mutual funds, not ETFs, despite the very confusing name (a pet peeve of mine). They are mutual funds that use ETFs as their underlying holdings. More to come.
@Fiona, the effect to your question is this does have an impact on the cost of capital. For companies considered “ESG”, or maintain their inclusion in these indexes, it increases demand for their equity and fixed income (i.e. higher stock prices, lower interest rates) and makes it easier for them to raise capital.
Conversely, companies that aren’t in ESG screens with have less demand for their equity and fixed income, driving stock prices down and interest rates up (to incentivize people to invest, they need to offer a higher risk premium), and ultimately raising their cost of capital.
Access to cheap capital is important for growth, so the concept is ESG adoption makes it easier for companies that have sound environmental, social, and governance practices to grow, and it makes companies that are can’t meet the ESG criteria more difficult to grow.
Lots of debate and research as to at what point it makes this impact, if not already. I believe it will continue to have an impact more so if institution investors continue to adopt ESG strategies as they have been.
If an oil spill is a reason to exclude pipelines, would severe unpublished side effects of some drugs be a reason to exclude pharmas ? Since smart phones are causing huge cyberaddiction issues, should smart phones manufacturers and mobile network operators be excluded ? Since industrial food processing can be linked to multiple health issues and risks, should “Big Food” be excluded ? Due to the number of death and injuries caused by car accidents, should that be a reason to exclude car manufacturers ?
If we were to use that approach, there wouldn’t be a single company left because all companies create negative consequences.
@Adam Thank you for the explanation. That makes sense.
@Linda Rocco. I think the idea is a pipeline company with a good safety record would be included, but one a bad history of spills is not. As for the list of industries that are excluded altogether, I think that’s been driven by what certain institutional investors with special interests, like church groups that don’t want to have any investments in gambling, alcohol, or adult entertainment, have asked for. I think their argument would be, while cars, for example, have both positive and negative repercussions for society, alcohol and adult entertainment have little or no redeeming social benefit and we would be better off without them at all.
Hi, we’ve recently started switching to ESG ETFs so perfect timing! How does this compare to WSRI and WSRD? Thanks!
With the recent introduction of EMXF by iShares in the US, it looks like these portfolios may have exposure to emerging markets soon! :)
@Fiona Gregory: I remember a study that linked easy access to pornography with a reduced rate of sexual aggressions so there might be positive aspects to it. Alcohol consumption also more positive health benefits than soda’s and industrial juices. So should we deem Coca Cola, Pepso and large industrial juice companies as non-ESG ?
Since Luxury is a sin, will these religious goofs push for the whole luxury economy (car brands, clothing brands, spirits, hotels, etc. to be removed ?
@Linda I know! While I could get behind some of the exclusions, others not so much….Might have to get off the potato couch and buy a few stocks in my favourite sins just to even things out! ;-)
To follow-up on my previous comment/question, I would like to add the following request:
The next time you update your model portfolios, could you possibly also recommend an ESG option? Instead of XEQT, perhaps GEQT, WSRI or WSRD? Instead of XBB, perhaps XSAB, ESGB or other?
If it helps, I found the following pdf document that compares a bunch of ESG ETFs, dated July 2020:
Thanks again for converting us to the CCP way. We have been a believer and a follower for several years now.
@Andrew: Thanks for the suggestion. Sorry to disappoint, but I am not planning to add an ESG option for the model portfolios. I’m agnostic about ESG strategies, as I think they are very personal, and I don’t fee qualified to recommend any specific funds in this category.
@CCP: Thanks for your response, although I hope you will reconsider one day. For those who don’t care about any ESG strategy in particular, we just want a set of ESG CCP (passive, minimal fees, diverse) ETFs that track the markets and that would allow us to sleep a little easier at night. Thanks again!
A bit unrelated but just noticed the model portfolios no longer include the 3 ETF portfolio (vcn, zag, xaw). I have been following it for a few years. Any important reason it was removed? Should I consider selling and using one of the 2 portfolios remaining?
@ Jackie: Full explanation here:
Hey, Dan, how are you doing? (This is Dan still writing for CCP, right?)
Are you back to blogging regularly? Any chance of resuming the podcast in the near future?
How many stock and bond holdings do each of these funds currently have, and how do they compare to their total-market counterparts?
Surprised to see the “Can you expect higher returns?” section of the article go on to look at historical returns. Maybe I have been following the Rational Reminder for too long, but I was expecting a delve into factor exposure and regression, lol. Wonder what Ben Felix would have to say about these new ETF’s.
@Mark H: Thanks for the comment. It’s still me. :) Not sure how regular future blogs will be, but Justin and I have been working on some things together (blogs + videos) so we’ll see how that goes. I’m not ruling out returning to podcasting, but no immediate plans yet.
For those trying to ask Dan or anyone else to recommend a balanced “Environmental, Societal and Governance” ETF, be aware that these are all highly subjective values. For myself, I have learned that even nuclear power generation (an option that I used to reject without a second thought) has been associated with some green advantages, according to some environmentally credible sources, given that all the non-nuclear alternatives generate some significant environmental and atmospheric damage. It’s not easy choosing, and it’s not as straightforward as one would like to think it is.
Is there a risk inherent in investing in such new funds? Obviously we can’t see how they have fared over time, but I’m especially concerned that there’s very little money held in these ETFs as opposed to larger Vanguard or Ishares funds. Are these solid to hold over the long term?
So would I be taking a big risk switching my entire 7 figure portfolio from XEQT to GEQT? Seems to provide as good or better returns with very slight bump in MER and huge impact on environment. Am I missing something and putting myself and life savings at risk by doing this?
@Jason: Only you can make that decision after researching the fund yourself. Certainly there is a risk of GEQT delivering a return that is quite different from that XEQT, since it holds only about 10% of the stocks and a different sector allocation. But GEQT is still very will diversified with almost 1,000 stocks in the US, Canada and developed overseas markets. It’s hardly a speculative investment.
Thank you very much for this video and the information you provide. I’m very interested in moving to ESG etf investing but what you said about how personal it is resonated with me. Would you know a resource for being able to research the different esg etf options to be able to choose one from a performance and personal preference standpoint
@Nathan: Thanks for the comment. I would start here: https://www.goodinvesting.com/research