As a new generation comes of age and begins to amass investable assets (whether earned and saved or inherited), advisors everywhere have been forced to adjust to a changing set of mentalities, expectations, and approaches to both financial planning and investing. For all that has been said about the millennial generation, one thing is clear: they have high expectations of those in leadership positions, from elected officials to corporate executives and even their own employers. Those high expectations have translated into a surge in interest in "sustainable investing" or "socially responsible investing" -- in layman's terms, a desire to invest in companies that not only make money, but also make the world a better place.
Indeed, a recent report from Morningstar (available here) found that more than 70% of all investors had expressed an interest in socially responsible investing, a figure that climbed well above 80% for millennials. However, interest among advisors lagged behind, as more than 60% reported "little or no interest" in those same strategies, while fewer than 10% described themselves as "highly interested". What's behind this gap between investor desires and advisor inclinations? Are advisors simply missing the boat, and is their reluctance to embrace the trend costing them business? What, exactly, is sustainable investing, anyway? Read on as I try to fill in the gaps.
A growing interest among investors
In part, the growing interest in sustainable investing strategies is a response -- and perhaps a backlash -- to the industry-wide trend toward passive, ETF-based index investing. The benefits of passive indexing (especially those that rely upon low-cost ETFs) are, by now, well established in the portfolio management industry, touted even by such investing luminaries as Warren Buffett and Peter Lynch.
But for all the tax benefits, trading ease, and fee savings that index ETFs present, there are also some significant drawbacks for those investors who care deeply about the types of investments they own. After all, the larger the basket of stocks you own, the more likely there are to be a few stocks in that basket whose business practices you disagree with, no matter who you are or what your viewpoints might be. Investing in an index ETF, then, can mean investing -- albeit indirectly -- in companies whose businesses you might despise, and whose stocks you would never elect to own on an individual basis.
The S&P 500 Index, for example (and by extension, the dozens of ETFs and mutual funds that track it), includes shares of oil companies (Exxon, Chevron), tobacco companies (Philip Morris, Lorillard, Reynolds American), banks (JPMorgan, Goldman Sachs, Bank of America), chemical companies (Monsanto, Dow), fast food companies (McDonald's, Yum! Brands), and more. Since all of these companies are considered controversial by at least some audiences, it's to be expected that some investors would be a bit wary of owning their shares, even if they're only doing so via an intermediary. In fact, just a quick scan of the top 100 component companies in the S&P would be sure to turn up at least 3 or 4 companies that nearly any investor would turn up their nose at if they realized they owned them.
Other asset classes are similarly afflicted: a high-yield bond ETF, for example, will tend to have oversized holdings of financial and energy companies, and an emerging markets ETF could be heavily concentrated in China, which is viewed unfavorably by many investors because of its checkered history with respect to human rights and environmental concerns.
Defining the new opportunity
Of course, if you go on like this long enough, you're bound to go blind (and, to be honest, trying to distance yourself entirely from unsavory companies or funds tends to run into some roadblocks eventually), but that doesn't mean it isn't worth an effort. The problem, from the financial industry's standpoint (and from an advisor's standpoint) is trying to define the terms "sustainability" and "social responsibility" in ways that can be broadly applicable among a wide variety of different clients. Unfortunately, social responsibility ultimately seems to be in the eye of the beholder.
In putting together their previously-cited report on sustainable investing, Morningstar included a CFA Institute list of a full 18 metrics across 3 categories (environmental, social, and governance, or "ESG") that could all be considered part of a "sustainable" strategy, from the perspective of an investor. From energy efficiency and labor standards all the way to lobbying activities and executive compensation, the list represents basically a comprehensive encyclopedia of potential bad acts (or, from a glass-half-full perspective, potential good acts) by a large corporation.
It's hard to imagine that any company could score highly on all 18 of those metrics, or even that most investors could care equally about all 18. Conversely, it's pretty likely that one investor could be very interested in environmental factors, to the exclusion of all others, while another economically-minded investor might care deeply about the role of executive compensation (perhaps recognizing that growing income and wealth inequality presents unsustainable economic trends over the long run).
That difficulty in defining the term leads to some strange results, to be sure. According to data from US SIF, the Forum for Sustainable and Responsible Investment, assets in funds that are defined as having a "sustainable" focus have grown tenfold over the last 20 years, to the point that current investments in socially responsible funds now exceed $6 trillion.
The statistic seems impressive, but it's at least a bit misleading. With the definitions of "sustainability" and "social responsibility" varying widely (and changing on a dynamic basis), it's become easier and easier for existing ETFs to declare themselves as part of the group, if only by making de minimis changes to their investing approaches. Yes, in some cases the companies who comprise these ETFs are making actual changes to their policies and governance in order to better qualify as "sustainable," but it's hard for an investor (or an advisor) to separate the wheat from the chaff in such a rapidly changing environment.
Indeed, if everything qualifies as sustainable, then the definition ceases to hold real meaning, and the investor is forced to dig deeper in order to find investments that really align with his or her own core values.
The "niche" sustainable ETF market
For most socially-conscious investors, it's clear that simply doing a Google search for "sustainable investing ETFs" or the like won't do much good, since it doesn't actually cull down the available universe of funds very much. That often means searching for more "niche" ETFs, which can vary widely both in quality and in strategy. Doing the fund research can be a daunting task for an individual investor, and even many advisors may lack the requisite familiarity with the companies that make up the funds in question.
Furthermore, the smaller a "niche" gets, the more compositional issues start to come into play; in other words, the benefits of diversification can start to go out the window, which compromises the benefits of using an ETF (or mutual fund) in the first place. Fees can also end up being higher for these funds, largely because competition (and pricing pressures) are lower in these areas than in more established areas like S&P 500 funds or aggregate bond market funds.
As an example, a quick scan of funds that focus on "green energy" companies turns up a couple of initially promising options. But the limited scope of the funds leads to a heavy concentration in just a few companies: the PowerShares Clean Energy ETF (NYSEARCA:PBW) holds more than 35% of its assets in its top 10 holdings, while the Guggenheim Solar ETF (NYSEARCA:TAN) has a top-10 holding concentration of 55%. That's pretty heavy exposure to just a few names, and the expense ratios are relatively high, as well (clocking in at 0.70% for both funds). Concentration and volatility tend to go hand in hand, and the last several years of performance of these two funds (spoiler alert: it's not great) confirm that linkage.
For the most part, it is this combination of low diversification and high expense ratios that have made advisors reluctant to recommend these sorts of funds to their clients. In addition, though, my experience as an advisor has taught me that certain investors seem to view a "sustainable investing" slant as a replacement for -- rather than a supplement to -- traditional asset allocation techniques. For all the obvious allure and potential long-term benefits of investing in "good" companies, the impact on portfolios is not well understood, if it is understood at all.
A lack of empirical data always makes money managers nervous, and that helps fuel a reluctance to embrace new products, new philosophies, and new approaches. That reluctance may come from a good place -- advisors are hoping to protect their clients from unnecessary volatility and portfolio uncertainty -- but it might also frustrate clients, especially during periods when traditional approaches underperform.
The role of individual stocks
For those investors who are adamant that sustainable investing strategies play a role in their portfolio, turning to individual stock holdings is almost certainly the best way to meet that need. Researching individual companies whose policies, procedures, and internal governance structures are well-aligned with an individual investor's own personal core values can be both a rewarding experience and an educational one. That said, the inevitable loss of diversification that comes from embracing an individual-stock approach (not to mention the difficulty of rebalancing, the increased trading costs, etc) means that an investor should always limit the amount of assets that are devoted to such a strategy, lest the overall portfolio volatility exceed the individual's basic risk tolerance. Again, sustainable investing should be a supplement to -- and not a replacement for -- classic asset allocation and diversification techniques.
Any sustainability-minded investor should set a cap on the amount of assets that they will devote to the strategy (say, 10%), just as they would do with any other asset class within their portfolio. Some investors may be willing to devote a higher portion of their assets to the strategy, but they should (and must) do so with the recognition that they are almost certainly adding volatility to their portfolio by doing so. If their risk tolerance is otherwise low, then they may be forced to choose between meeting their risk tolerance goals or their social responsibility goals.
Of course, as interest in socially responsible policies and companies continues to grow, the companies themselves are beginning to adjust as well. More and more companies are starting to make progress on at least a few of the 18 ESG categories identified above, which makes the job of the socially responsible investor much easier (at least in theory). For some companies, this shift has come from an increasing recognition that embracing sustainable policies can make financial sense, even in the short term (hotel towel washing procedures come to mind). For others, it has come in response to pressure from investors, consumers, or both.
Given the current landscape, while investing in the shares of socially responsible or sustainable companies is certainly a laudable goal, the individual investor's role as a consumer holds at least as much importance. If Americans young or old want to send a message to companies about how they should conduct themselves, that message is almost always best sent (or at least most expediently sent) via real-time sales figures, or a lack thereof. When a firm's quarterly financial statements suffer as a result of failing to embrace sustainable policies, change is almost certain to come.
Either way, it's clear that advisors, fund managers and investors will have to pay attention to sustainability issues both now and for years to come. This is a trend that promises to keep growing, and hopefully the entire world will prosper as a result.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Business relationship disclosure: The author is a contract employee and partial owner of myFinancialAnswers.com, and he is compensated to provide industry commentary for the site. The opinions provided here may also be published at myFinancialAnswers.com.