Jun 7, 2022
How to build a portfolio with ESG ETFs
About 50 years ago, religious foundations started asking their portfolio managers to avoid putting money into “sin stocks” – companies in the alcohol, tobacco or weapons industries. Little did they know then that they would start a movement that now reaches across the entire investment management industry.
Today, there are numerous Canadian-listed Environmental, Social and Governance (ESG) Exchange-Traded Funds (ETFs) to choose from, while a record $1.6 billion flowed into Canadian-listed ESG ETFs between January and April of this year, according to National Bank’s monthly ETF report. While that’s good news for people who want to take a more value-based approach to investing, having so much choice can make it confusing to figure out how to build a portfolio with these kinds of securities.
Damian Fernandes, Managing Director, Fundamental Equities at TD Asset Management Inc. (TDAM), points out that people’s value systems have become broader, which has made it harder to find investments that perfectly align with their thinking. Today, responsible investing can help encompass everything from environmental sustainability and climate change to racial and gender equality, Indigenous rights and corporate governance, among other things.
Excluding all possible offenders would leave a small and unrepresentative segment of the investable stock and bond universe open for investment. That’s why there’s now more emphasis on ESG criteria that move responsible investing away from a binary decision – such as investing in oil stocks or not – to a more nuanced and holistic analysis of an organization’s impact on the Earth and on society. “As ESG picks up momentum, you should be able to deliver broader societal objectives, so you have a virtuous circle at play,” he says.
Today, investors and their advisors have two broad ways of approaching ESG, says Trevor Cummings, Vice-President, ETF Distribution for TDAM. They can opt for thematic mutual funds or ETFs that, for example, target companies in the renewable energy space. But, given their volatility, these funds are often used as bolt-ons to a more diversified core portfolio. Fortunately, investors and their advisors can now choose to replace their core funds themselves with ESG-focused products that behave very much like a broad index fund.
“It’s more about trying to avoid the pitfalls of the broad market,” Cummings says of creating a portfolio with core ESG funds rather than broad-market ETFs. By only investing in companies with above-average ESG scores within their sectors, core ESG funds simultaneously give unitholders similar performance to market benchmarks and help reduce the risk of lawsuits, boycotts, work disruptions, regulatory penalties and other negative externalities that could weigh on corporate profits and returns, he explains.
ESG building blocks
In 2020 and 2021, TDAM rolled out in total a suite of five such building-block ESG ETFs, offering exposure to Canadian, U.S. and international equities, along with Canadian and U.S. corporate bonds. “The five ETFs we offer cover the broad majority of asset allocation in a portfolio,” Cummings says.
While they have limited exposure to government bonds and emerging-market equities, due to the difficulty of rating these areas for ESG, “as far as building a foundation for a portfolio is concerned, we think these five are a great place to start,” he notes.
Once these funds are in place, investors and advisors can then build certain exposures on top, such as adding ETFs that aim to generate higher yields or returns through specific exposure to certain sectors or industries, albeit with greater risk.
Some of these core funds do own extractive industries such as mining or fossil fuels – though the companies they hold have sustainability policies in place and must be ESG leaders in their field. But for those who don’t want to own any energy stocks, TDAM does have a series of actively managed sustainability mutual funds, which exclude these kinds of companies.
ESG is a journey, not a destination, especially for businesses. Among public companies competing for capital, ratings create incentives for ever-better ESG performance that, together with other factors such as social media’s impact on a company’s reputation and mounting concern over climate change, have already moved the needle on corporate conduct and practices.
“ESG is only going to grow in importance,” Fernandes predicts. Governments and regulators are encouraging it; clients are demanding it; historical returns support its use as a risk-mitigation tool. “This conversation isn’t going away.”
Start the conversation
With all the volatility in stock markets so far in 2022, now’s the perfect time for investment advisors to begin a conversation with their clients around ESG, says Cummings. “As we reassess portfolios, this is a great opportunity to introduce ESG as a concept,” he explains.
Surveys show ESG is a widely supported investment priority, one that’s particularly popular among young investors and women. By offering index-tracking portfolio building blocks that nonetheless offer ESG characteristics for only a few basis points more in management fees than an index fund, advisors can demonstrate their value proposition. “We’ve crossed a threshold,” Cummings says. “It used to be, ‘Why would I do this?’ Now it’s, ‘Why wouldn’t I do this?’”
“To me these ETFs are a no-brainer, because you get broad market exposure at likely lower risk levels while also pushing the envelope on corporate social responsibility,” adds Fernandes. “It’s almost like a free lunch.”