Investing with Purpose

But what about the means themselves? Some clients have wondered whether investments can help make a change. Not only investing “for” a purpose but investing “with” purpose. Not only “Can I make a difference by investing?” but also “Can my investments make a difference?”

The easy answer is yes. There is a large and growing number of purposeful investment options. But the full answer is more complex.

Investing with purpose likely began in the 1970s, when some faith-based colleges and other institutions sought to align their foundations with their organizational missions. That most often took the form of exclusionary screens, e.g., no tobacco or alcohol. Such “socially responsible” investing eventually made its way into retail funds as investment managers bet on a wider audience.

At first, investors had relatively few choices. A handful of investment companies did offer “social” or “sustainable” funds, but they tended to have relatively high costs and concentrated portfolios. Moreover, most did not have a transparent selection process. Although one could read a fund’s philosophy and values, it could be difficult to understand how individual companies would or would not end up in the portfolio.

That has changed. Today, investors have myriad choices, as well as a word salad to describe them. Clients have expressed some confusion regarding differences between investments described as “social,” “socially conscious,” “impact,” “socially responsible,” “sustainable,” “SRI,” and “ESG.” Today, we’d like to shed some light.

Investing with purpose is a large, complex, and growing field. Thus, our piece today will be more primer than panacea. We’ll discuss the terminology, review the impressive rise of investment options, and explore some methods that allow investors to align their values with their investment portfolios.

Alphabet Soup: Impact vs. SRI vs. ESG
As noted above, the financial industry uses many names for values-based investing; investors sometimes feel confused wading through the terminology. Although they all try to describe the same phenomenon – expressing values through investments – there are some differences. To avoid confusion, we won’t dive into the more general terms like “social” or “impact” and instead focus on two of the most frequently used terms: SRI and ESG.

“Socially Responsible Investing,” or “SRI,” became a buzzword several years ago. It encompasses many aspects of impact investing. Too much, perhaps, as investors were uncertain exactly what they were getting with an “SRI” fund. For example, one manger “seeks to invest in issuers that balance the needs of financial and nonfinancial stakeholders and demonstrate a commitment to the global commons, as well as to the rights of individuals and communities.”¹ That’s a laudable goal but, in our opinion, doesn’t provide investors much clarity regarding the portfolio.

Most recently, investment managers have used the term “ESG” to refer to socially conscious investments. ESG stands for “Environmental, Social, and Governance” criteria and identifies three main categories. “Environmental,” not surprisingly, refers to criteria evaluating a company’s impact on the environment, including fossil fuel and other energy reserves, carbon emissions intensity, factory farming, and nuclear power. “Social” refers to a variety of concerns relating to corporate practices. These can range from relatively common social issues like alcohol, weapons, and tobacco to more recent concerns such as human trafficking, predatory lending, and child labor. “Social” also encompasses an array of religious and spiritual issues, including stem-cell research and pork production. “Governance” refers to company management structure and employee relations, and covers issues like executive compensation, proxy votes, and gender diversity.

Going forward, we prefer to use “invest with purpose” or “investing with purpose” to describe the process through which investors express their values through their investments. And we’ll use “ESG” to describe individual funds or investment strategies that allow investors to invest with purpose.

Recent Explosion
Investors today have a great deal more options when selecting ESG funds. Over the last 20 years or so, we’ve seen an explosion in the number of ESG strategies (see graph). Several factors have contributed to this phenomenon. First is greater demand. As issues like climate change receive more news coverage, more people seek to take action, including changing their portfolios.

Earlier this year, for example, the country’s attention focused on the deeply unfortunate issue of gun violence. Grassroots organizations began a campaign to encourage investors to divest from gun manufacturers. In response, several investment managers have announced they will offer new firearm-free investment strategies. Generally, we welcome manager response to changing demand from investors and hope this trend continues.

Another reason for more ESG funds is more available and standardized data. Across the globe, companies report an increasing amount of information regarding ESG factors. The more information investment managers have, the better they can distinguish between individual companies. That means investors can have increasing confidence that actual investment portfolios are consistent with a given fund’s value and objectives.

Finally, more investment managers are using sophisticated risk models to help ensure their portfolios track relatively closely to an investment benchmark. Traditionally, ESG funds tended to have flexible investment mandates to allow the manager to implement the social goals. Today, many funds use an array of statistical techniques to keep their portfolios more in line with an underlying benchmark. Doing so allows investors to use funds in discrete areas of the market, for example large US value companies, as part of an overall portfolio toolkit.

There are three main methods through which investors can invest with purpose: private funds, publicly traded funds, and separately-managed accounts (SMAs).

Private Funds
There are many private funds available to investors, each with its own specific mission and focus. Because of the large number of funds, and a relative lack of public information, it’s possible to make only the most general observations. Many private funds are not diversified, not subject to reporting requirements, and tend to have higher administrative costs than publicly traded funds. Moreover, private funds may have strict guidelines restricting when investors can withdraw their funds. Although individual private funds may do good work, we don’t recommend private funds in our client portfolios due to the lack of diversification, liquidity, and transparency.

Public Mutual Funds and ETFs
As the previous chart shows, there are a large and growing number of publicly traded ESG funds. They can be either traditional mutual funds or exchange-traded funds (ETFs).² The biggest advantages public ESG funds offer are diversification, simplicity, and cost. Most funds provide a diversified portfolio of stocks or bonds. Investors can buy or sell shares each day. Although ESG funds as a group tend to have higher costs than non-ESG funds, the cost of adding an ESG element has declined over time. Today, investors can find ESG funds with yearly expenses modestly higher than traditional funds, roughly 0.1% to 0.25%.

Note there can be disadvantages to ESG funds. One potential complication is finding a fund that shares your values. As we’ve explained above, investing with purpose covers a wide variety of environmental, social, and political concerns. For example, some investments exclude most or all gun manufacturers. A “no-gun” portfolio may be very important to some, but not to others. Similarly, some funds exclude companies that engage in stem-cell research. That’s a hot-button issue about which individual investors may disagree strongly.

Another potential issue is how investment managers implement their ESG portfolios. Some funds will “screen” out companies entirely that fail to meet one or more of the manager’s impact criteria. Doing so removes unwanted companies entirely from the portfolio but can reduce overall diversification. Others won’t exclude companies but rather reduce or “tilt” their exposure in the portfolio. Such tilts better diversify the portfolio and help ensure that investors get returns consistent with the fund’s asset class. On the other hand, some investors don’t feel that a fund consisting of, say, 2% of an unwanted company is materially better than an index fund with 3%.

Separately Managed Accounts
Finally, investors can invest with purpose using a separately managed account (“SMA”). An SMA is an account managed by a third-party investment manager. SMAs provide diversified portfolios of stocks or bonds but, unlike a fund or ETF, the investor’s money isn’t pooled with others. Instead, the investment manager buys dozens or hundreds of securities for the SMA owner. See comparison chart.

The SMA format provides some unique benefits. First, SMAs can offer a large degree of customization. Many SMA investment managers allow account holders granular control over the ESG rules. Want to exclude a particular company? Check. Want to avoid an entire sector? Check. Want to overweight companies with low environmental impact? Check. SMAs thus provide a powerful tool through which investors can help ensure an investment manager incorporates their values into a diversified portfolio. Second, an SMA is completely transparent. At any time, the investor can look at each individual company in the portfolio and know exactly what she owns. Third, SMAs can offer some additional tax flexibility in taxable brokerage accounts. Because the investor owns many individual companies, the manager may periodically harvest losses, thereby reducing or deferring taxes. Finally, SMA account holders generally may use proxy votes for individual companies to have even more impact.

Like funds and ETFs, SMAs also have their downsides. First, investors need to open a new brokerage account for each SMA. Logistically, you open a new account, fund it, and then hire a third-party investment company to manage the account over time. If you want three different managers, you may need three new accounts. Second is the relative complexity of the accounts themselves. Most SMAs have hundreds of holdings and may trade those holdings hundreds of times per year. Note this is the flip side of the transparency. With mutual funds or ETFs, investors don’t see the underlying holdings and trades. But SMA holders do. That means more trade confirmations, longer monthly statements, and more complex tax documents. Third is larger minimum account sizes. Many SMA managers require a minimum of $250K to open an account, and some require as much as $1M per account. For many investors, this means liquidating a large portion of their portfolio, and realizing material capital gains. Finally, SMAs can reduce investors’ ability for “asset location:” putting more tax-efficient investments in taxable accounts and less tax-efficient investments in IRAs and other tax-advantaged accounts.

A Conversation
We help clients build wealthier lives, in part, by asking them big questions about what they want. More and more, clients tell us that they want to align better their financial wealth with their values. We’ve thus thought deeply about what options clients have and we continue to review the rapidly growing world of ESG funds. As with financial plans, there is no single “best” ESG portfolio. Instead, we believe investing with purpose provides another opportunity to learn about our clients’ values and find ways to allow them to express those values through their portfolios.

If you are interested in learning more about investing with purpose or ESG funds, please let us know. We welcome the conversation.

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¹ The Calvert Principles for Responsible Investment, calvert.com.
² Both mutual funds and ETFs are publicly traded, pooled investment vehicles. The main difference is that investors buy and redeem mutual fund shares directly from the investment company and buy and sell ETF shares on an exchange, like shares of stock.