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.

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:

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.