Blog
(4 minutes to read)
With so many options for environmental, social, and governance (ESG) investing today, creating an investment portfolio that best aligns with your values and preferences can feel overwhelming. It can be difficult to discern which investment products focus on the issues you care most about. From there, it can be challenging to combine them into a cohesive mix that can also meet your investment objectives for investment return and acceptable risk. Let’s break this process down so you know what to expect when building an ESG investment portfolio.
First, some context. ESG investing got its start in the 1960s and came to be known first as socially responsible investing (SRI). Investors “screened out” companies from their portfolios based primarily on ethical considerations—for example, excluding alcohol and tobacco producers. In the mid-2000s, environmental issues became more prominent, along with concern over the way in which companies managed social and environmental issues through their corporate governance structure, leading to the now-common term ESG. Today’s ESG investors both screen out undesirable companies and industries and promote the companies and industries that align with their values by investing more heavily in them. It can be a compelling approach, when done right.
The first step in creating your ESG investment portfolio is identifying which ESG issues are the most important to you, in a positive and negative sense. Some common areas that investors consider are:
Adult entertainment
Alcohol
Carbon emissions
Clean energy companies
Climate commitment ratings
Factory farming
Gambling
Genetically modified organisms (GMOs)
Governance ratings
Nuclear power
Oil and gas
Palm oil production
Predatory lending
Tobacco and cannabis
Thermal coal
Weapons and ammunition
Women on boards
There are several more areas, as well as many subareas. (A more complete list of potential ESG issues would require numerous pages.)
Every ESG investor has a different set of preferences within these common ESG areas. For example, some investors are most interested in environmental factors, like oil and gas production, carbon emissions, and climate commitment ratings, and are less concerned with alcohol. When interviewing couples about their ESG preferences, we often find differences and disagreements within the same household. There is no standard set of factors for ESG investing that applies to all investors—investors are all different—which makes it difficult for ESG investment product providers.
Major index fund providers, including Avantis, BlackRock iShares, Dimensional Fund Advisors, and Vanguard, now offer ESG versions of their products. Each fund provider must make choices about which ESG areas to focus on in their products, based on their understanding of what the majority of investors want. One provider might lean more heavily toward environmental concerns. Another might emphasize social responsibility. Each fund provider weights each of the ESG areas differently in their various exchange-traded fund (ETF) and mutual fund products.
What this means is that a key part of building an ESG portfolio is attempting to match your set of ESG preferences to the investment products that are the closest fit to your preferences. For example, one provider’s products might match 50% of the ESG issues you care about most, while another provider’s products match 80% of what’s important to you. It all starts with understanding what you value most, then learning what areas are included in the available products, and then selecting products for your portfolio that have the greatest overlap with your values. There probably won’t be any one exact match—instead, you’ll be looking for the best match possible.
As you review the different ESG product providers, you’ll see how different they can be in what they focus on and how they weight companies, based on the areas they’re emphasizing. That can make it difficult to mix and match funds from different providers in a single portfolio. As a result, it’s usually best to stay within a single fund family to ensure consistency of ESG goals across your portfolio.
If a set of off-the-shelf investment products doesn’t match your preferences closely enough, there is another option: you can consider a custom-designed ESG portfolio. With a custom portfolio, you can specify exactly which industries and companies to exclude or emphasize in exactly the amounts you want.
Custom ESG portfolios can be created and maintained in a “separately managed account.” (You may also hear separately managed accounts referred to as direct indexing or personalized indexing.) With a separately managed account, instead of holding ETFs or mutual funds in your brokerage account, you hold all the individual stocks and bonds that are inside of those ETFs or mutual funds. That way, you have much greater control about which individual company’s stocks and bonds to exclude.
Of course, like everything you buy, custom products cost more than off-the-shelf products. However, with brokerage firms now offering zero-commission stock trading, and with the continued increase in computer power, the cost of separately managed accounts (direct indexing) has become more affordable. It’s now possible to build completely custom ESG portfolios for a small additional cost compared to the cost of an ESG portfolio built with ETFs and mutual funds.
ESG investing is based more heavily on your individual preferences than other investment processes. To build an ESG portfolio, first take an inventory of the environmental, social, and governance issues that are most important to you. Then, select from among the large and growing number of ESG investment product options available to best match your values and preferences. If off-the-shelf investments don’t match your preferences closely enough, consider a custom-designed ESG portfolio in a separately managed account (direct indexing).
Parkworth Wealth Management provides holistic wealth management services including financial planning, equity compensation planning, investment management, tax planning, and others, on a fee-only basis and as a fiduciary, acting in clients’ best interests. If you’d like to become involved in ESG investing so that your investments better mirror your personal values, schedule a complimentary consultation.
