ESG ETFs Can Be a Core Component of a Diversified Portfolio | ETF Trends

Investors who are interested in socially responsible investments can fine tune selections and diversify with a sustainable ETF strategy based on environmental, social and governance principles.

On the recent webcast, Strategies for Sustainable Portfolio Construction, Benjamin Lavine, Chief Investment Officer, 3D Asset Management, and Sean Edkins, Head of ETF Sales and Strategic Partnerships, DWS, explained that socially responsible investing incorporates more than just environmental aspects like climate change, protection of natural resources, pollution and ecological opportunities, but it also includes social and governance factors as well.

Specifically, they explained that the social aspect includes health and safety, product liability and the supply chain.

“In the social arena, we look at supply chain issues to make sure companies are using sustainable practices there and that they are not obtaining items from too questionable of sources or regimes. We also look at how employees are being treated and product liability concerns too. These items can definitely play a role in a company’s well-being or reputation over the long term and we feel it is a mistake to not include these potential flash points,” Edkins said.

Lastly, the governance principle is based on corporate governance and corporate behavior.

“We are looking at how companies are owned, the pay and board structures, and then general business ethics. We think these non-financial factors can often have a financial impact and that’s why we are take them into account with our ESG process,” Edkins added

Furthermore, investors do not need to give up anything to maintain a socially responsible investment portfolio. In fact, academic research has revealed strong evidence that environmental, social and governance factors positively influence corporate valuation and investment performance. Looking at over 2,000 academic ESG performance studies, DWS has found 90% of results demonstrate that prudent sustainability practices have a positive or neutral influence on investment performance, 88% of companies with robust sustainability practices demonstrate better operational performance and cashflows, nine of the GICS Sectors saw stocks with superior ESG scores signal lower earnings volatility, and companies with high ESG ratings tend to have a lower cost of capital.

“It really makes sense when you think about it… Companies with better governance are, well, governed better. This can often translate into superior performance,” Edkins said.

“Highly-rated ESG stocks also tend to produce higher returns on capital and are more highly profitable,” Lavine said.

The ESG theme is also not some fringe or niche investment that is relegated to a satellite portfolio position. Over one-quarter of assets under management globally, or more than $22 trillion, are now being invested according to the premise that environmental, social and governance factors can materially affect a company’s performance and market value. ESG integration has been growing at 17% per year.

Lavine pointed to some recent examples of real world instances that are beginning to push companies to respond, such as modest signs of improvement in the health and safety performance of some mining operations and the consequences of human rights abuses in Asian fisheries and aquaculture that can affect the global food chain.

“Our case studies demonstrate the legal, reputational and financial toll of inhumane labor conditions,” Lavine said.

Wealth and demographic shifts may also contribute to growing interest for ESG investments, notably the rising income and wealth among the millennial and women groups. Edkins pointed out that millennials could have net worth in the $20 trillion range and 90% of millennials have shown intentions to allocate to responsible investments over the next five years. Additionally, $30 trillion is expected to pass from baby boomers to millennials over the next two to three decades. Meanwhile, female investors are twice as likely as their male counterparts to consider sustainability alongside return when investing, and their projected 38% income growth in the period from 2016-2021 suggests that it is increasingly a group that cannot be ignored.

“In other words, both are seeing huge gains in income and influence, and they appear to be interested in ESG investing. This is where the money is going to be and we feel as though it is a good idea to keep their interests in mind when creating portfolios of the future,” Edkins added.

As a way to incorporate ESG investments into a diversified portfolio, Austin Fitch, Senior Analyst, Horizon Investments, argued that investors need not give up core allocations since ESG investments can overlap with these traditional market exposures. While ESG investments have not experienced the same booms as traditional growth stocks, companies that follow ESG principles have exhibited smaller swings that could help investors capture improved risk-adjusted returns over the long haul.

To help investors diversify with the ESG theme, DWS has come out with a suite of ESG ETFs, including the Xtrackers MSCI EAFE ESG Leaders Equity ETF (NYSEArca: EASG), Xtrackers MSCI Emerging Markets ESG Leaders Equity ETF (NYSEArca: EMSG) and Xtrackers MSCI ACWI ex USA ESG Leaders Equity ETF (NYSEArca: ACSG). Additionally, the more recently launched Xtrackers S&P 500 ESG ETF (SNPE) is among the first ETFs to track the S&P 500 ESG Index, the environmental, social and governance derivative of the widely followed S&P 500 Index. Edkins also explained that all five have fees at 20 basis points or less including USSG, which has a 0.10% expense ratio, so that investors can find options that can act as core components of a portfolio at a low cost.

Financial advisors who are interested in learning more about ESG-factor investments can watch the webcast here on demand.