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An introduction to Social Responsibility Investing with ETFs

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Can our portfolio choices do the power of good to the environment and society as well as our personal wealth? SRI investors believe so...

An introduction to Social Responsibility Investing with ETFs

If you like the idea of aligning your investments with your values then take a look at Socially Responsible Investing (SRI) ETFs.

SRI indices track firms that take a positive approach to environmental, social and corporate governance (ESG) issues. This can be anything, from focusing on firms producing green tech or actively managing their carbon footprint to favouring companies that promote ethical and sustainable business practices. SRI indices are also likely to exclude so-called sin stocks - firms up to their neck in the alcohol, tobacco, arms, gambling, pornography, fossil fuel and nuclear industries, among others.

Although SRI is a fast-growing sector, the idea of influencing society through investing is not a new one.

 

In good company

The Quakers are often credited as pioneers of socially responsible investing, as they forbade their members to profit from the slave trade in the 18th Century. Other religious organisations have worried about ill-gotten gains too and regularly used the pulpit to steer their flocks away from vice-like liquor and guns.

The social revolution and increased attention to UN human rights accelerated developments in the 1960s and 1970s. The first stock indices with ethical guidelines were constructed in the 1990s. Sustainable investment practices received a further boost with the Principles of Responsible Investing and the associated non-profit organisation UNPRI. Today, numerous institutional investors and investment companies are members of the UN initiative launched by then UN Secretary-General Kofi Annan in 2007.

The SRI sector has blossomed ever since as more ETFs and funds arrived enabling investors to direct their cash towards green themes such as clean energy or water and, increasingly, towards broad-market SRI ETFs. European investors place much more value on sustainable ETFs than investors from other regions of the world: around 60% of all funds invested in sustainable ETFs come from Europe. 

Since the beginning of 2020, 23 billion euros have been invested in sustainable ETFs alone, while many other investment strategies have seen significant outflows. As a result, the funds invested across Europe rose to 52 billion euros in more than 300 equity and bond ETFs.

That number is likely to increase as many market participants believe that ESG companies are best placed to meet the challenges of the future - think pension sovereign wealth funds reducing their exposure to fossil fuel firms, for example. There is also evidence that millennials and women are more and more interested in SRI – Morgan Stanley found that 70% of females and 84% of millennials believed that ESG factors were important.

 

SRI performance

But is SRI too good to be true? Do you have to compromise your principles for performance?

Several studies have examined this question and concluded that SRI funds largely perform on a par with their conventional counterparts and can beat them.

How can good triumph over evil? Firms that are ESG-compliant often operate more efficiently. This translates into better cashflows, a lower cost of capital and, ultimately, a superior performance. Such companies are also better positioned to take advantage of the opportunities afforded by sustainable business practices.

 

MSCI Europe SRI vs MSCI Europe

MSCI Europe SRI vs. MSCI Europe

Source: justETF Research; as of 31/08/2020


In the example above, the ETF on the MSCI Europe SRI significantly outperformed the conventional MSCI Europe-ETF over the past three years. So it shows that SRI indices can do as much for your conscience as they can for your ETF portfolio.

 

How do SRI indices work?

SRI indices vary a lot, so it is important to make sure that your chosen ETF tracks one that matches your concerns.

Often an SRI index starts as a clone of a well-known parent index such as MSCI World. Firms that are not in line with the index's principles are excluded. For instance, MSCI World SRI knocks out companies with their fingers in the following pies:

  • Alcohol
  • Gambling
  • Tobacco
  • Armaments
  • Firearms
  • Adult entertainment
  • Genetically modified organisms
  • Nuclear power
  • Thermal coal

Many companies are conglomerates so they will be red-carded if their sin revenues top a certain size or if they’re fundamentally involved as a producer, supplier or distributor of such products.

Some indices enhance exposure to companies that score highly against ESG criteria, such as environmental practices, respect for human rights and employee treatment, by increasing the weight of these companies.

The screening process implies that an SRI index is concentrated than its amoral parent – MSCI Europe has 435 constituents versus only 114 for MSCI Europe SRI (as of 31/08/2020).

However, some indices compensate by retaining their parent’s regional and risk-return characteristics.

As one might expect, MSCI is the dominant index family with respect to SRI. Although there are also indices from other providers, each featuring its own moral code:

 

Moral focus of SRI indices

Moral focus of SRI indices

*further exclusion in subindex 
Source: justETF Research; as of 31/08/2020


 

SRI ETF selection

Naturally, the choice is the winner as the popularity of SRI ETFs grows. You can invest responsibly in a global SRI ETF; across regions like the Emerging Markets; in single countries or in single, sustainable industries such as clean energy. You can invest according to religious principles too, as, e.g., with iShares MSCI World Islamic ETF.

Another thing to know before you go off to polish your halo is that many SRI ETFs have a relatively small amount of assets under management. ETFs that fail to grow in size run the risk of being closed by their providers which could leave you sitting out of the market until you are able to redeploy your cash. However, the market now offers a sufficient number of large sustainable equity ETFs with a corresponding history. To find SRI ETFs search justETF's screener using the filter social/environmental.

Our tip: Are you interested in theme investments such as water, electric mobility or clean energy? Then use our new investment guides.
 

Green bond ETFs

In addition to the now established sustainable equity ETFs, an increasing number of green bond ETFs are entering the market. As with equity ETFs, the companies and partly sovereigns behind the financial instrument are reviewed, selected or excluded on the basis of sustainability criteria.
 
The methodology is similar to the one used for evaluating equity issuers. MSCI, the market leader for equity indices, cooperates with Bloomberg Barclays, a well-known provider of bond indices.