Investing with an environmental, social and governance (ESG) lens can be simple in concept – align your portfolio with your values – but it can be a lot more difficult to do in practice, especially when it comes to ensuring companies do indeed have the right ESG credentials.
At the moment, the asset management industry doesn’t follow a single set of ESG standards. Some fund managers screen out companies engaged in problematic activities like making tobacco products or gambling. Others proactively target organizations producing renewable energy or developing technologies to assist the energy transition. Some score companies relative to their industry peers, others avoid certain industries, such as fossil fuels, altogether.
Investors and advisors, then, have to understand and have confidence in the methodologies their fund manager uses to decide which companies should go into their ESG fund. “When you talk about ESG, it really is a question of trust,” says David Roode, vice-president, director of ETF Products and Strategy at TD Asset Management Inc. (TDAM).
That’s why, when TDAM set out to create a suite of ESG exchange-traded funds (ETFs) in 2020, it partnered with Morningstar and Sustainalytics, an offshoot of Morningstar, who focuses on rating securities for ESG compliance and tracks some 15,000 public companies worldwide.
TDAM, which has deep experience in both ESG (with actively managed mutual funds) and index ETFs, worked with Morningstar to come up with a series of indexes of companies with strong ESG metrics, via a combined negative and positive screening process.
To determine whether a company should be included in an index, Morningstar first conducts an ESG screen. This involves using a Sustainalytics controversy score, and if the score is too high, meaning that a company is more likely to be involved in a damaging controversy, the company is removed. Second, there is a negative screen to weed out businesses engaged in any objectionable activities, such as controversial weapons like nuclear, tobacco products or gambling. Lastly, again leveraging Sustainalytics ESG risk ratings, Morningstar then takes the top 67% of the remaining companies that have the lowest ESG risk ratings. Those companies get included in the index. It’s a similar process with bonds, with the company taking the best 50% of corporate issuers by ESG rating. You can compare these ETFs with the ESG Investing at TDAM Brochure.
Based on those indices, it built three equity ETFs: TD Morningstar ESG Canada Equity Index ETF (TMEC), TD Morningstar ESG U.S. Equity Index ETF (TMEU) and TD Morningstar ESG International Equity Index ETF (TMEI). All three began trading on the Toronto Stock Exchange in December 2020. “These products are the lowest-cost solutions in the Canadian marketplace at 10, 15 and 20 basis points, respectively,” Roode asserts.
These ETFs can help investors already comfortable with broad-market index investing transition into ESG funds. All three offerings correlate strongly with the performance of the broad market, yet still come with a slightly lower risk profile. While TDAM's funds do include fossil fuels they only hold businesses that pass the rigorous ESG screens that are implemented.
Diversifying with ETFs
In the interest of providing a full set of ESG ETFs for Canadian investors, TDAM also launched the TD Morningstar ESG Canada Corporate Bond Index ETF (TMCC) and TD Morningstar ESG U.S. Corporate Bond Index ETF (TMUC), again with very affordable 15- and 20-basis-point management fees, respectively. These fixed-income funds, which put corporate bond issuers through the same screening process as stock issuers, made their TSX debut in 2021. “We’ve got all the building blocks that are essential for a balanced portfolio,” Roode says.
“Whenever you’re adding an ESG strategy to a portfolio it is often about risk reduction,” adds Jonathan Needham, vice-president & director, ETF Distribution for TDAM. “You’re eliminating the potential controversies, the bad apples, if you will.”
It’s up to investors and their advisors how they want to use TD ESG ETFs, Needham says, but they were designed to allow investors to build or switch into a complete and diversified portfolio that will behave in a no less predictable way than the broad market. This year’s challenging market conditions have proven the worth of diversification, he notes.
The beauty of index ETFs is they offer instant diversification at a very low cost. And for investors still building their nest egg, there can be a silver lining to the market downturn.
“If you’re building a balanced portfolio with building blocks like ours, we believe the longer-term prospects are better today than six months ago as valuations have come down and yields have improved," Needham emphasizes.
So, for advisors and their investors who have been meaning to align their values with their investments, now seems like an opportune time to do so.