Feb 15, 2021
How to build a portfolio with ESG ETFs
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It wasn’t long ago that ESG (environmental, social and governance) funds were used by only a few socially conscious investors as an add-on to an already built portfolio. Over the last few years, though, demand for these products has soared – as of December 31, 2020 assets under management in Canadian ESG funds climbed by 37% year-over-year, according to Institutional Shareholder Services (ISS). [1]
As more people choose to invest with their values – that could be buying companies that treat employees fairly or businesses that are actively trying to reduce their carbon footprint – more are looking to build entire portfolios out of ESG offerings, says Damian Fernandes, global portfolio manager at TD Asset Management Inc. (TDAM) in Toronto.
That’s been especially true since the COVID-19 pandemic, which has put a spotlight on everything from how frontline workers are paid to gender diversity issues within companies and more. It’s also made people think more carefully about what motivates them – in life and in money.
“The COVID-19 pandemic has helped people refocus on what really matters to them,” says Fernandes. “With investing, more people are looking at factors outside the financial statement. More clients want a portion of their portfolios invested in companies that match their values, and companies with strong sustainability credentials may outperform others.”
At the end of 2020, there were 144 Canadian-made ESG-focused funds on the market – up from 116 in 2019, according to ISS. About 42 of those offerings are exchange-traded funds (ETFs), a low-cost, liquid and easy-to-purchase investment vehicle that more people are using to create long-term portfolios.
“ETFs expand the options, allowing investors and their advisors to target portfolios in a certain direction,” Fernandes notes. “Funds are great building blocks for a portfolio, but ETFs may allow more focus.”
ESG Investing Has Evolved
It used to be difficult to build a truly balanced portfolio using strictly ESG assets, but with the evolution of both ETFs and ideas around ESG, creating a diversified mix of ESG-focused stocks and bonds is doable, even in Canada where energy, a sector that has often been avoided in ESG funds, makes up a large part of our market. Yet, some investors and advisors still think it’s impossible to do, in part because they don’t realize how this market has evolved.
“Traditional ESG was based on excluding companies whose products might be controversial, such as tobacco or fossil fuels – that was a limited view.” Fernandes says. “Today’s ESG investments look more holistically at the companies and their role at large; instead of excluding certain sectors or companies, they recognize companies that are moving in a positive direction.”
For instance, an oil and gas company can make sense in an ESG fund if its leaders are working to minimize their carbon footprint or meeting other sustainability goals. Usually, the sponsor of the ESG fund requires the companies included in the product to meet specific environmental, social or governance practices. Investors can look at the sponsor’s requirements to determine whether their values match up with what’s in the fund.
For example, TDAM, which has, for many years, pressed the companies it invests in to be more responsible, believes that one of the pillars of a strong company is a diverse board of directors. If a firm doesn’t have at least 30% female directors, TD votes against the next director. Not only does this practice the company’s values, but research shows it’s also good for financial results, Fernandes says.
Portfolio Considerations
Whether you’re an advisor or a do-it-yourself investor, building a portfolio with only ESG ETFs is similar to traditional portfolio construction, save for one difference: the process starts with a focus on values. To do it well, Fernandes recommends following these steps.
Evaluate the sponsor’s sustainability requirements
Start by determining whether your values line up with the sponsor of a particular ETF. Fund sponsors post their sustainability requirements publicly; for instance, you can read about the criteria TDAM follows here. “Ask yourself, ‘Are my values aligned with theirs? Are they doing things that enact change?’” Fernandes says.
Determine the right allocation
As with any investment portfolio, what you buy will depend on a variety of factors, from long-term goals and risk tolerance levels to time horizon and income needs. That’s no different with ESG. Retail investors may want to work with an advisor to help them determine what their goals are and what kind of asset mix is appropriate, while advisors should know that today’s ESG market can account for every kind of financial situation, whether that’s a need for additional income, lower volatility, additional growth or other factors.
Build your strategy
With more choices on the market than ever before, building a core portfolio with ESG ETFs is easy. For instance, TDAM recently launched three broad-based ETFs – Canadian, U.S. and international-focused – which take a variety of ESG factors into account. If you want international exposure, then you could consider the TD Morningstar ESG International Equity Index ETF (TMEI), which holds 366 companies located across the globe, including Europe, Japan, other Asian countries and more.
With the TD Morningstar ESG Canada Equity Index ETF (TMEC), investors get exposure to 77 domestic operations, including many brand name companies that Canadians are familiar with, such as the major banks and railways, and tech companies like Shopify and Open Text. The TD Morningstar ESG U.S. Equity Index ETF (TMEU) holds 438 stocks across a variety of industries. Those three ETFs alone can serve as the core part of any diversified equity portfolio.
However, you don’t just have to choose ETFs that have the ESG label in their names. For example, some fund companies, such as TDAM, apply their ESG philosophy to all their products. If you want more dividend exposure, there’s the TD Active Global Enhanced Dividend ETF (TGED); if you want more tech, consider the TD Global Technology Leaders Index ETF (TEC). They may not be labelled as ESG-specific funds, but they’re built with ESG principles in mind.
If you’re still skeptical about building a portfolio out of all ESG investments, just look at the returns, says Fernandes. Most ESG funds have delivered comparable, if not better returns, than traditional ones. In 2020, for instance, the MSCI Canada ESG Leaders Index, a cap-weighted index that provides exposure to companies with high ESG ratings, posted an 11.25% return compared to 6.21% for the MSCI Canada index. Since the ESG index’s inception in September 2007, it’s performed two percentage points better – 4.61% compared to 2.58% – than its more general Canadian counterpart.
That kind of performance, especially in a pandemic year, proves that an ESG portfolio can be good for both wallets and the world.
“When the COVID-19 pandemic began making news and shutting things down, ESG investments performed well – and they continued to perform well as good news of vaccines boosted the markets,” says Fernandes. “ESG is here to stay and acceleration is likely to persist.”