In this day and age, morals and values are taking precedence in how some investors construct their portfolios. Socially responsible investing (SRI), as it is aptly dubbed, seeks to bridge the gap between profits and purpose. The major followers of the SRI style take stock in various environmental, social and governance (ESG) metrics when crafting their portfolios.
These ESG metrics can cover a wide array of factors, including how a firm treats its workers, if it ethically sources its raw materials/ingredients, what sort of executive compensation it has and carbon emissions.
Putting these factors into some sort quantifiable index for investing seems like a daunting and impossible task. Luckily for investors, SRI index sponsors have several techniques to take the subjectivity of ESG out of the equation – making it very easy for investors to add a dose of SRI to their portfolios with exchanged-traded funds (ETFs).
The heart of crafting an SRI index comes down to scoring a stock on various ESG factors. Using data, public filing information and models, index providers hope to take the subjective nature out of ESG. For example, indexing powerhouse MSCI will look at 1,000 different data points related to ESG policies, programs and performance. Those data points will be broken down into categories – 80 exposure metrics, 129 management issues and 37 industry-specific metrics – and a stock will essentially be given a letter grade.
While most index providers may not be as thorough as MSCI, the basic principal is the same: looking at a firm’s history and public information, and then scoring it accordingly to a model.
Positive, Negative and Restricted
Once they have an entire universe of stocks – domestic, international, European – scored, index providers will run one of three kinds of screens to craft their portfolios. Negative, Positive and Restricted Screens form the backbone of modern SRI/ESG indexes and ETFs.
In a negative or exclusionary screen, analysts will look to remove stocks that score poorly or are from certain industries. The beginnings of SRI investing came from these sorts of screens. Here, industries such as tobacco, firearms, gambling and alcohol are removed from an index. More modern negative screening techniques will remove these sectors plus all the firms scoring below a certain threshold.
In a positive or best-in-class style screen, managers will hone in on the best scoring firms. After an initial score threshold is created, stocks scoring above this will be included in the index. Ranking and other requirements can change the index, but the basic gist is the same.
An offshoot of positive ESG screening is thematic screening. Indexes looking at certain ESG specific factors such as women’s rights or solar energy fall under this category.
Finally, most modern ESG indexers use what’s called a restricted screening process. This seeks to evaluate a firm based on its own unique set of issues, depending on what sector it is in. For example, energy stocks would have more weight placed on them in the environmental category than, say, a financial firm. The idea is that if a firm has some activities in a less-than-desirable sector, but it’s only a small part of its operations, it can be considered for an ESG index. In a negative or positive screen, the stock may be kicked out. SRI purists balk at this sort of screening method, but the inclusion of some “less-than-pure” stocks could be why ESG has finally started beating regular indexes.
Putting It Into Practice
Here at ETFdb.com, we track 23 different ETFs that are considered “socially responsible.” That number doesn’t include categories like water or renewable energy. Here are some of the biggest.
iShares MSCI KLD 400 Social ETF (DSI ): At more than $605 million in assets, the DSI is the largest and most well-known SRI ETF. The fund is a prime example of a restricted screening fund. Index provider MSCI first kicks out all tobacco, gambling, firearms/weapons, nuclear power, adult entertainment and GMO seed producers in the USA Investable Market Index, which covers large-, mid- and small-cap stocks. It then uses various socially responsible investing screens based on sector-specific criteria to score and weight DSI’s holdings to create its underlying portfolio
SPDR SSGA Gender Diversity Index ETF (SHE ): At nearly $300 million in assets, SHE offers a unique take on SRI/ESG investing. The positive screened fund will track the SSGA Gender Diversity Index. The benchmark is a measure of large-cap U.S. stocks that are considered gender-diverse. That means SHE’s underlying portfolio of stocks will have greater gender diversity in their senior leadership positions. Academic research shows that firms run by women perform slightly better than their counterparts in return on equity and stock market returns.
iShares MSCI ACWI Low Carbon Target (CRBN ): With roughly $245 million in assets, CRBN is the largest example of an ETF using an exclusionary screen. Like the name suggests, the fund focuses its attention on companies that produce lower carbon emissions. The global fund will screen for firms with high levels of carbon pollution and then eliminate them from the broader MSCI ACWI Index.
Finally, both the Guggenheim Solar ETF (TAN ) and PowerShares Water Resources Portfolio ETF (PHO ) are the largest prime examples of ESG thematic indexes. Both funds hone in on environmentally friendly and necessary sectors within socially responsible investing. In this case, solar energy and water-related filtration, infrastructure and products.
Doing ‘Good’ & Indexing
Similar to regular stock market investing, indexing in SRI is alive and well. The difference is the complexity of the various factors needed to screen for these sorts of funds. However, the main ETF issuers have pretty much got it down to science. Following a basic framework, sponsors are able to craft a variety of ESG/SRI ETFs for your portfolio. The previous examples are just some of the unique ways investors can bring their values to their portfolios.