Perhaps you've learned about Environmental, Social, and Governance investing (ESG) and have decided that you'd like to take advantage of this approach in your own portfolio, seeking to align your investments with your social or environmental goals instead of considering only risk and returns. Now the question becomes: How do you go about building an ESG portfolio? Do you have to change all of your investments, or can you tiptoe into ESG? We're here to help.
A spectrum of ESG portfolios
You can think of your personal degree of ESG involvement within your investments on a spectrum. On one end of the spectrum, you might be "all-out," and ESG doesn't come into play at all. On the other end, you might be "all-in," where ESG is completely embedded in every inch of your portfolio. And you might be somewhere in between. It's okay to pick a point to start with and then move along that spectrum when you feel comfortable doing so.
All-out: The lowest level of ESG involvement is what we call "all-out." This is the default starting point for most of us, where our investment decisions are all about meeting financial goals, earning good returns, and controlling risk. Social and environmental factors might come into play in your charitable giving or volunteer activity, but not in your investments. This is okay! And it's where investors typically begin.
Exploring: At the "exploring" level, you might add an ESG fund to an otherwise non-ESG portfolio. You could for instance, sell a non-ESG fund in one part of your portfolio (for instance, a large-cap U.S. fund) and then buy an ESG fund in the same asset class. This way your overall portfolio is relatively unchanged, but you can have some exposure to investments that better align with your values.
Middle-of-the-road: At the "middle-of-the-road" level, you can take ESG options where you can easily find them and stick with non-ESG options otherwise. For instance, you might have a well-diversified asset allocation plan in mind and use ESG funds to fill most of the broad equity slots (U.S. large cap and small cap, international developed markets). You might also use ESG funds for diversified fixed income or corporate bonds. For categories with few or no ESG options, a middle-of-the-road plan uses non-ESG funds, such as in real estate, emerging market bonds, government bonds, precious metals, etc.
Focused: With a "focused" approach to ESG, you could specifically seek out investments across your entire portfolio that align with your ESG preferences. This can be done by picking off-the-shelf mutual funds, exchange-traded funds, and/or separately managed accounts for all of the asset classes you want to invest in, or by hiring an advisor who specializes in building portfolios to align with your ESG preferences.
All-in: The approach for an investor who is truly passionate about ESG is what we call "all-in." With an all-in approach, you build an ESG portfolio from the ground up, researching your own underlying investments and putting them into a complete portfolio, security by security. While the all-in approach maximizes the alignment between the portfolio and your values, this approach can be time-consuming and difficult.
ESG tools you can use
Once you've decided where you want to be on the ESG portfolio spectrum, it's time to pick your tools. Fortunately, you have some choices.
Mutual funds: There are more than 300 mutual funds identified by Morningstar as "Sustainable Investment – Overall," which aligns with how Schwab classifies ESG. Most of these funds are actively managed, but there are some index-tracking options. While there are ESG mutual funds in over 60 Morningstar categories, the largest number of options can be found (in descending order) in the U.S. equity, international equity, taxable bond and allocation asset classes. The ease of accessing these funds and their breadth across categories is a positive, but keep in mind that you can't personalize a mutual fund—you own whichever securities the fund manager decides to own. And you usually can only get an update on the specific securities the fund owns once per quarter. Of course, there are also fees to consider, which can be as low as a tenth of one percent for some of the lowest-cost index funds to more than 2% in some instances.1
Exchange-traded funds (ETFs): There are more than 150 ESG ETFs based on the same "Sustainable Investment – Overall" data point from Morningstar, and unlike mutual funds, most of these are passively managed. These funds can be found in about 40 Morningstar categories, but the majority of funds are in the equity asset classes (U.S., international, and sector equity), with fewer options available in fixed income. Like mutual funds, ETFs do not provide you with flexibility to personally customize your portfolio. However, most ETFs provide daily disclosure of their holdings, so you can usually see exactly which securities are held by the ETF each day. Fees for ETFs are often lower than for mutual funds, since most ETFs track indexes; only two ESG ETFs have an expense ratio over 1%, and there are 100 such funds with expenses under half a percentage point.1
Separately managed accounts (SMAs): An SMA is a portfolio of individual securities managed on an investor's behalf by a professional asset management firm. There are SMA managers who offer Environmental, Social, and Governance strategies. However, some SMAs can also provide investors with the option of customizing their portfolios. This can be helpful if you know exactly which stock (or group of stocks) you would like to exclude. Finding SMAs is not as simple as finding mutual funds or ETFs, and costs tend to be higher than for mutual funds and ETFs.
Stock-by-stock or bond-by-bond research: If you want maximum control over your investments in order to align them to the highest degree with your ESG preferences, you can build a portfolio piece by piece by researching each security that you buy and evaluating its social and environmental quality. Obviously, this takes time and requires that you keep track of how the parts come together—are you too exposed or underexposed to any sectors, countries, or asset classes? But if you really want to know what you own, you can buy your stocks and bonds one by one.
Putting it together
ESG strategies can help you achieve goals beyond just investment returns. Schwab's research has generally found that ESG funds as a whole have fairly similar risk and return characteristics as non-ESG funds. However, keep in mind that because ESG strategies exclude some securities, they may not be able to take advantage of the same opportunities or market trends as non-ESG funds. Additionally, the criteria used to select companies for investment may result in investing in securities, industries or sectors that underperform the market as a whole.
If you're ready to get started with an "Exploring ESG" portfolio, consider picking a single mutual fund or ETF whose investment objective sounds like it aligns with your values. To go deeper into a "middle-of-the-road" approach, you might choose several funds in different parts of your portfolio, looking beyond the investment objective and actually examining what the funds own.
If you want to move into a "focused" or "all-in" ESG approach, you might want to seek out more customized help—a separately managed account that lets you specify what you want to avoid, or an advisor who specializes in a style of ESG that matches your values. But if you want the best possible match to your own preferences, you might just consider doing all your own research and buying only those stocks and bonds that fit your ESG desires. The choice is yours.
1 Morningstar Direct data as of 7/31/2021
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The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Because environmental, social and governmental (ESG) strategies exclude some securities, ESG-focused products may not be able to take advantage of the same opportunities or market trends as products that do not use such strategies. Additionally, the criteria used to select companies for investment may result in investing in securities, industries or sectors that underperform the market as a whole.
Socially screened strategies that use screening exclude certain investments and therefore may not be able to take advantage of the same opportunities or market trends as strategies that do not use screens. There can be no assurance that the strategies will achieve their desired outcomes. Each investing strategy brings with it its own set of unique risks and benefits.
Diversification and asset allocation strategies do not ensure a profit and do not protect against losses in declining markets.
Investing involves risk, including loss of principal.
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