How to Build an ESG Portfolio -- And Why You Should

·6 min read

Investors interested in environmental, social and governance issues often cite climate concerns as guiding their ESG investments.

They were rewarded during the market crash as oil prices cratered. In the first quarter, sustainability-focused funds held up better than the broader fund market during the initial bear market sell-off -- driven in part by less exposure to fossil fuel energy.

That said, ESG goes beyond not buying petroleum companies; there's the "S" and the "G" parts, too, and those may take greater prominence as people focus on health care amid the pandemic and the social unrest triggered by systemic racism.

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Recent data from financial services firm Morningstar showed continued investor interest in ESG. The global sustainable fund universe attracted $45.6 billion in the first quarter of 2020, versus an outflow of $384.7 billion from the overall fund universe. In the U.S. specifically, the research firm found that in the first quarter, flows into open-end and sustainable exchange-traded funds reached $10.5 billion, eclipsing the previous record set in 2019's fourth quarter.

A June survey from global investment manager Nuveen showed high-net-worth investors are starting to choose ESG for its outperformance, in addition to having a positive social impact, with 53% of respondents citing returns as their top reason to invest in ESG.

If you're thinking about revamping your portfolio to include more ESG holdings, here are a few points to keep in mind:

-- Sustainable funds lost less this year.

-- ESG requires long-term, broad-based thinking.

-- How to build an ESG portfolio.

Sustainable Funds Lost Less This Year

All equity funds lost money in the first quarter, but ESG funds lost less than their conventional counterparts.

Morningstar data showed that of the 206 sustainable U.S. equity open-end funds and ETFs, 44% ranked in their category's best quartile for returns, and the returns of 70% of sustainable equity funds were in the top halves of their categories. Only 11% were in the bottom quartile.

Narrowing it to sustainable index funds, the data showed that of the 26 sustainable index funds available, 24 outperformed conventional index funds. The research firm says one of the best-performing U.S. index ETFs was iShares MSCI USA ESG Select ETF ( SUSA). In the first quarter, the fund was down 17.8% versus a 19.6% loss for iShares Core S&P 500 ETF ( IVV), a conventional benchmark. The ESG ETF's outperformance continues as SUSA is down 3% year to date, while IVV is down 6.7%.

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In an April conference call, John Streur, president and CEO for Calvert Research and Management, an ESG investment management firm, attributed his funds' outperformance to the "very limited" exposure to the entire fossil fuel chain.

A second outperformance driver was using ESG metrics to own companies, he said at the time. In the initial reaction to the pandemic, companies that did well had some level of preparedness in terms of how they manage their employees and their relationship with their communities.

"Although no company really had criteria for how they would respond to a pandemic, it's clear that companies that had been thoughtful about managing other environmental or social risks were ready for any kind of situation and have reacted quite well," Streur says.

ESG Requires Long-Term, Broad-Based Thinking

Vikram Gandhi, a senior lecturer at Harvard Business School who developed and teaches a course on impact investing for the MBA program, says as society now looks at health care and systemic racism as key investment issues, the companies that did well in the initial pandemic response may also respond quicker to these other concerns.

"It's such a front-and-center thing," he says, "first with COVID and now what's happening with the protests. Having a stronger focus on employees and really the whole focus on all stakeholder concerns, all those things are starting to get a lot more focus."

Incorporating broader social concerns into your investing strategy can pay off as "companies that are perceived to do better in those areas actually tend to outperform," he adds.

Aashu Virmani, chief marketing and sales officer of Fuzzy Logix, who worked closely with LGBTQ Loyalty Holdings to build the LGBTQ100 ESG Index, says while the pandemic was a catalyst for ESG funds to outperform in the short term, ESG funds are constructed to do better over the long term.

In fact, many ESG-focused companies tend to be high-quality firms that value long-term performance over short-term profits.

How to Build an ESG Portfolio

As many funds have rebounded, you don't want to chase performance for performance's sake.

Making changes to a portfolio for any reason requires care and planning. Having a financial advisor or planner give you guidance may help protect you from inadvertently paying too much in taxes when selling or buying stocks or funds at a high price.

If you're interested in creating an ESG portfolio, take a look at the holdings of ESG funds that interest you. ESG funds are usually underweight in traditional energy names, Gandhi says, but they are often overweight in technology companies, which can leave you overexposed to that asset class.

Virmani says ESG investors should look closely at how a company or a fund scores on the three criteria -- environmental, social and governance -- rather than just one factor. These themes represent very different facets of a company's business.

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For example, a high governance score means a company will be run in a sustainable manner, while a high social score suggests a safe work environment in the broadest definition for all employees. Those types of companies usually have low churn rates, which creates a better cost structure for the company. Finally, strong environmental scores can make companies more efficient.

He says by focusing on all three factors, you're picking the "cream of the crop companies." Although no one can predict the future, a portfolio constructed with these types of companies should do better than a non-ESG counterpart, he adds, which is what we experienced earlier this year.

Gandhi reiterates that ESG investors need to think about the long term, not just what's going to happen in the next six to 12 months as the country reopens. Long-term thinking includes looking at what companies have a climate transition plan and offer transparency with both investors and the community; these factors are going to be critical.

If you don't have time to do bottom-up research -- taking a deeper look at individual firms -- he recommends an easy alternative. "The best way to do it is to focus on some ETFs," he says.

Debbie Carlson has more than 20 years experience as a journalist and has had bylines in Barron's, The Wall Street Journal, the Chicago Tribune, The Guardian, and other publications. Follow her on Twitter at @debbiecarlson1.