Socially Conscious ETFs
Socially conscious ETFs give investors a way to invest in issues that are important to them. These ETFs are often defined by their socially focused investing strategy.
What are socially conscious ETFs?
Socially conscious ETFs (exchange-traded funds) fall into an investment strategy often called impact investing or socially responsible investing (SRI) and strive to generate financial returns and make a societal impact.
Socially conscious ETFs are sometimes called ESG funds because of the types of issues that they support: environmental, social, and governance. To better understand this type of ETF, it helps to know how the three issues work as criteria:
Environmental factors consider how a company performs as a steward of the natural environment (e.g., a company's carbon emissions, air/water pollution, energy efficiency, raw material sourcing, and other issues related to environmental practices).
Social factors consider how a company manages relationships with its employees, suppliers, customers, and the communities in which it operates (e.g., a company's impact on human health, human rights, labor standards, gender diversity, employee engagement, and data protection/privacy).
Governance factors can include the quality and reasonableness of a company's leadership, executive pay, audits and internal controls, and shareholder rights (e.g., diversity of the Board of Directors, executive compensation, lobbying and political contributions, and business ethics).
What are the types of strategies behind socially conscious ETFs?
Understanding the strategies behind socially conscious ETFs can help you narrow down your ETF list. The following types of strategies commonly focus on ESG issues:
Excludes companies and sectors on the basis of particular values or moral standards. Exclusionary screens usually avoid companies that have business exposure to particular products or services (e.g., alcohol, tobacco, or gambling), but they may also be based on a company’s behavior (e.g., labor practices or environmental protection).
Refers to selecting or weighting companies with better or improved ESG characteristics relative to their peers. In the best-in-class approach, investors may be surprised to see an energy producer within the top holdings. However, this firm may be better rated than its energy-producing peers and have the risk and return characteristics necessary to minimize tracking error to the broader benchmark.
Also known as asset stewardship. Some asset managers actively engage with corporate boards to advocate and vote for the advancement of ESG issues, even for the assets of funds without specific ESG mandates. For example, a large ETF provider has recently made gender diversity a focus of its asset stewardship efforts. As a manager of passive funds, this provider asserts that its investments are long-term core capital. Therefore, it has a responsibility to manage ESG issues, which its asset managers believe are drivers of long-term performance, for all the assets under its supervision.
Refers to investing based on trends that may have ESG implications. For example, there are ETFs that invest exclusively in the producers of wind energy, solar energy, water, and organic products (of course, non-ESG investment themes are also available in ETFs).
A type of ESG strategy where producing positive environmental and social outcomes goes hand in hand with generating positive financial returns—for example, investing in companies that derive the majority of their revenue from addressing some of the world’s major social and environmental challenges (recycling services, electric vehicles, vaccine producers, etc.). Microfinance projects and sustainable banking may also fall into this category.
What are the pros and cons of socially conscious ETFs?
As you make decisions about your portfolio, it’s important to understand what socially conscious ETFs can offer and what to watch out for.
Socially responsible investing may provide intangible benefits for many investors. But as the case is with any ETF, socially conscious ETFs can help diversify a portfolio when mixed with other asset classes.
Since ESG research begins with bottom-up, company-specific data, much of which is voluntarily disclosed by the firms themselves, there is the possibility of incorrect or false reporting of a company’s socially responsible activity. Companies may unintentionally overlook their positive ESG activities or intentionally conceal damaging information, either of which makes the construction of accurate ESG portfolios more challenging. The Sustainability Accounting Standards Board (SASB) is a nonprofit organization that is working to improve the quality of the ESG information that is publicly disclosed to investors via SEC filings.
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