Caleb Jean breaks down socially responsible ETFs

This article from Caleb Jean, CFA and investment analyst with Desjardins Wealth Management, Securities, was published last month in Finance et investissement. In this Q&A, he explains socially responsible ETFs. This month, we’re passing this information on to you.

Watch out for sector concentrations of some products, cautions Caleb Jean, CFA and investment analyst with Desjardins Wealth Management, Securities.

Finance et Investissement (FI): Why should advisors take an interest in ETFs that respond to environmental, social and governance (ESG) factors?

Caleb Jean (CJ): Overall, 77% of Canadian investors are either somewhat interested or very interested in responsible investment, according to the Responsible Investment Association (RIA), which represents the Canadian responsible investment sector.

On top of that, millennials are a generation of investors who are sensitive to ESG factors. This group could also expect to benefit from a portion of the inheritance they will receive in the form of anticipated inheritance. A study conducted by CIBC in 2016 found that 2.5 million Canadians over the age of 75 collectively possessed assets with a net value of $900 billion, of which $750 billion will be passed on as an inheritance in the next 10 years. Canadians between the ages of 50 and 75 will constitute the largest group of beneficiaries.

The range of available responsible investment solutions is greatly diversified in Canada and the United States. In the world of exchange-traded funds (ETFs), however, Desjardins’ wide selection helps it stand out from the crowd.

FI: Why should people use an ETF to introduce ESG factors into their portfolios?

CJ: There’s a perception that the ESG sector is developing in a niche market. This would be true if the sector dealt only with renewable energy. However, ESG investments can be made in, say, water systems or electric cars. These industrial sectors are more common. The RIA found that 82% of investors would like to dedicate a portion of their portfolios to responsible investments and 77% agree that companies with good ESG practices make for better long-term investments. In addition, using ETFs as an investment vehicle enables investors to reach markets that would otherwise be expensive or difficult to access.

FI: Are ETFs readily available on the Canadian market? On the US market?

CJ: Looking at responsible investment solutions in Canada, mutual funds are more prevalent than ETFs, and the same trend can be observed across the border. But the arrival of an influential player like Desjardins Group lends a certain amount of visibility to this previously underdeveloped subsector of ETFs. The range of products encompasses the two main asset categories: stocks and fixed-interest securities. In the United States, there is a greater variety of socially responsible ETFs on offer due to the more diverse market. So, it’s possible to build a balanced portfolio that takes into account ESG factors without necessarily being more volatile than the market at large.

FI: Can you tell me about the stock-picking strategy for ESG ETFs?

CJ: Most ESG investment solution providers will base their selections on the recommendations of specialized outside firms that evaluate stocks and assign them an overall environmental impact score. The United Nations, with its Principles for Responsible Investment (PRI), and Morningstar, with its Sustainability rating, are both respected entities that are trusted to perform this type of evaluation. Next, investment solution providers make selections based on geographic area, stock type and sector.

FI: Do ESG portfolios ever include shares in oil companies like Suncor or shares in other carbon dioxide emitters?

CJ: There are two main approaches to building ESG products. First, there’s what we call the negative approach, that is excluding certain “immoral” industries. This filters out businesses dealing with gambling, alcohol, tobacco, weapons and fossil fuels. Then there’s the participative approach, which includes CO2-emitting industries working with either product providers or external evaluation entities to greatly reduce their emissions. So, products created following this second approach may include shares of CO2 emitters.

FI: Tell me about the defining characteristics of ESG ETFs, including the market capitalization of shares, sector concentrations, concentrations by country and other notable risks.

CJ: The most sought-after sectors are public utilities, high tech and energy. These sectors are mainly found in North America and Europe. Investments in innovation in these industries are more mature in industrialized countries, which results in having shares with higher market capitalization in those markets. But there are ESG subsectors that are highly concentrated in niche markets. For example, green technologies intended for renewable energy are considered to be volatile and to have low market capitalization, as they hold stock in wind and solar power and other alternative energies. Special attention should be paid to the sectors included in ESG solutions to determine their weight in a portfolio.

FI: Do ESG ETFs achieve returns net of fees that are comparable to those of passive ETFs tied to the major indices?

CJ: Looking at the few existing ETFs that have been around for at least three years, it’s hard to make a proper comparison, but Blackrock’s iShares Jantzi Social Index ETF (XEN), set up in May 2007, gives exposure to Canadian companies that meet a wide range of ESG criteria. Over periods of three and five years, XEN saw higher annualized returns as at October 30, 2018, than the S&P/TSX 60, which represents the 60 largest market capitalizations in Canada. That’s a concrete example of responsible investment adding value to a portfolio. RIA reported that in 2015, responsible investments accounted for 38% of assets under Canadian management. Based on its growth potential, this sector is likely to experience an upward trend in the future.

FI: What are the fees associated with these products and is it worth paying the higher fees compared to competing passive ETFs?

CJ: Management fess for ESG ETFs are higher than management fees for comparable passive strategies. On the other hand, actively managed ESG ETFs have management fees similar to conventional actively managed ETFs. In that case, it makes sense to integrate themed ETFs in a portfolio, considering that 82% of investors want to have a certain proportion of responsible investments in their portfolios.

It is quite likely that some of these ETFs hold stocks that are traded abroad, so it’s a good idea to minimize the effect of the bid-ask spread (the bid price less the ask price). The greater the difference between the bid price and the ask price, the higher the bid-ask spread. One good habit is to trade ETFs that hold European or other foreign stocks when markets in these areas are open. That will help you tighten the gap between the ETF bid and ask prices and, in doing so, reduce the spread cost.

FI: How can an advisor integrate ESG ETFs into their clients’ portfolios?

CJ: First, it would be wise to ask the client about how they feel about this sector and how much they know about it. Next, try to determine their risk tolerance. For a client with above-average risk tolerance, it would be appropriate to recommend investing 10% to 20% of their portfolio in actively managed or niche ETFs, like an ESG fund. For less risk-tolerant clients, you could recommend investing between 5% and 10% of their portfolio in a passive ESG ETF. Last, make sure to have a thorough understanding of the stock picking approach so you can meet the client’s desired environmental criteria.

FI: What are the main differences between ESG ETFs and other ESG products on the market, such as ESG mutual funds?

CJ: The difference between ESG ETFs and ESG mutual funds comes down to liquidity, transparency, cost and accessibility. ETFs give investors and managers access to specialized sectors at a lower cost. Mutual funds offer a greater variety of solutions at the moment. So, it’s best to do your homework and gauge which investment tools best suit the client’s investment profile, goals and constraints.