Want to Help Lower Client Taxes? How About ESG ETFs?

The supply of environmental, social, and governance (ESG) ETFs, as well as those that offer a counter-narrative to ESG investing, has expanded in 2022, even as the amount of money currently invested in all of these funds remains minimal. However, a recent PWC study showed that assets tied to ESG investing in general were expected to double over the next few years. One of the potential demand drivers we at VettaFi see in the final months of 2022 is tax-loss harvesting efforts by advisors.

I’m far from a tax expert, so I’m outsourcing the description of tax-loss harvesting to Charles Schwab, who make it sound simple. First, you sell an investment that’s losing money — in 2022, that is the easy part with the S&P 500 Index, the Nasdaq 100 Index, and most other equity benchmarks down sharply.

Then, you use that loss to reduce your (or your client’s) taxable capital gains and potentially offset up to $3,000 of ordinary income. Finally, you reinvest the money from the sale into a different security that meets your (or your client’s) investment needs and asset allocation strategy. 

To avoid violating the wash-sale rule, Schwab says you should use the proceeds from that sale to purchase a similar — but not substantially identical — security that suits your asset allocation and long-term investment plan. Unfortunately, the government has not provided a straightforward definition of what it considers “substantially identical.” Advisors and end clients will have to use their best judgment to avoid the wash-sale rules.

So how does ESG fit in? The SPDR S&P 500 ETF (SPY), the world’s largest ETF, was recently down 24.1% in 2022. However, State Street Global Advisors also offers the SPDR S&P 500 ESG ETF (EFIV), which provides large-cap U.S. equity exposure with a twist incorporating attributes, such as climate policies and business conduct. EFIV was down 23.6% in the same period we measured SPY. 

EFIV holds approximately 60% of the holdings found in SPY, with exclusions of some notable companies, such as Berkshire Hathaway, Johnson & Johnson, Meta Platforms, and Tesla, and overweightings to companies with perceived strong ESG attributes like Apple (9.7% vs.7.0%), Microsoft (7.8% vs. 5.6%), and UnitedHealth Group (2.1% vs. 1.5%). Despite these differences, the sector weights for EFIV and SPY are intentionally similar, as the underlying index looks for companies within a sector. EFIV charges a 0.10% expense ratio that is slightly above that of SPY.

If you owned the Invesco QQQ Trust (QQQ), which was recently down 33.7%, there’s an ESG version — the Invesco ESG Nasdaq 100 ETF (QQMG)  available for the same 0.20% fee but down 34.1% because it is constructed differently. 

QQMG owns 97 stocks, six fewer than QQQ, with Meta Platforms again one of the companies missing from the ESG portfolio. However, the more notable difference between the two ETFs can be found by looking at the position sizes. Microsoft represents 14% of QQMG (10% for QQQ), while Amazon.com and Tesla account for just 3.7% and 2.6% of the fund (6.9% and 4.2%, respectively, for QQQ). While QQMG has just $9 million in assets, ETF liquidity is primarily derived from the underlying holdings, with new ETF shares easily available to be created. It is hard to imagine many more liquid collections of stocks than those in the Nasdaq 100.

What if you owned small-caps through a fund like the iShares Core S&P 600 ETF (IJR) and were down 21.4% this year? Yes, you guessed it — there’s an ESG ETF alternative to consider. 

The Xtrackers S&P SmallCap 600 ETF (SMLE) launched last year and charges a 0.15% fee. SMLE is indeed small with only $9 million in assets, far less than the $61 billion IJR. Yet SMLE is not identical and indeed was outperforming IJR by 100 basis points. SMLE holds 383 positions (36% fewer than IJR) and has overweights to Agree Realty Corporation, Livnet Corporation, and SM Energy. SMLE also has an ESG sibling, the Xtrackers S&P 500 ESG ETF (SNPE) that tracks the same S&P ESG index as the aforementioned EFIV.  

EFIV, SMLE, SNPE, and QQMG provide similar yet different exposure to more established core equity ETFs, but are constructed with an ESG and not purely a market-cap perspective. While a minority of investors have embraced ESG ETFs based on their personal values, another minority of investors have sought out alternatives because they feel personal values should have nothing to do with investing. 

However, the majority of ETF investors are looking for market-like returns without giving ESG a further thought. Perhaps heading to the end of year, they and their advisors want to think a little longer about what some ESG ETFs can do to help them.  

For more news, information, and strategy, visit VettaFi.