Current Sustainable Investing solutions do not meet investor needs because they do not ensure high-quality ESG evaluation or active engagement with companies on ESG outcomes.
Existing Socially Responsible solutions for all are through mutual funds or ETFs and it does not live up to the expectations
Most Socially Responsible solutions are offered through mutual funds or ETFs created by large financial institutions like Blackrock or Vanguard. Mutual funds and ETFs are large pooled asset vehicles, where an individual investor does not control the underlying portfolio. Many simply track an overall index or industry. For example, an ETF can buy all the stocks of the biggest 500 companies (S&P500) in proportion to their overall market value.
In the old days, these funds were great because they allowed investors with small amounts of savings to get a lot of diversification at a low cost (and remember, diversification is good!). However, to function, they need to attract a large pool of investors. You need a large number of people to send you money to buy all the stocks of the S&P500 in proportion to their weight and to have low fees.
Therefore, mutual funds and ETFs are incentivized to take a moderate approach to appeal to the largest number of potential investors. And this applies to Socially Responsible ones especially. To attract as many investors as possible, financial institutions are using the lowest common denominator. For example, iShares ESG Screened S&P 500 ETF, one of the largest Sustainable ETF from BlackRock, includes 460 out of 500 of the largest companies in its portfolio. This means they think 92% of the companies are sustainable!
Finally, investing through ETFs does not allow you to get your voice heard at the board of companies. You are not directly the owner of the underlying stocks (the companies) which means that you do not directly vote on shareholder resolutions or engage directly with management. Your opinion does not count when voting resolutions, and/or agreeing with the board on policies or compensations. Instead, Fidelity or BlackRock, the creator of these ETFs are the ones that will have their say thanks to your savings and they are not always aligned to your values.
Devils lies in the details
In most existing ESG funds, large financial institutions use narrow exclusion principles. Back to our example, BlackRock only excludes companies that are involved in "controversial weapons, small arms, tobacco, oil sands and shale energy, thermal coal and fossil fuel reserves". This means both companies with dubious business practices and companies with clearly unsustainable industries are included, for example:
- JP Morgan with USD 31 billion in fines since 2000 is part of the index. Strange when those fines were clearly related to the primary mission of the institution: toxic securities abuses, mortgage abuses, investor protection violation, banking violation, or anti-money-laundering deficiencies.
- Halliburton or Baker Hughes are two of the world's largest oil field service companies. Salty when the COP26 explicitly acknowledged their role in climate change.
But it gets even worse!
Some criteria are applied fairly loosely. For controversial weapons, "all companies with direct involvement or via an ownership stake of greater than or equal to 25% of companies involved in the core weapon system, or components/services of the core weapon system" mentions their website. A company with significant interests in weapon manufacturing could still be considered as sustainable.
Towards new solutions for sustainable investment for all
Thanks to new technologies and solutions in the investing landscape, the attractiveness of ETFs is fading away. Direct indexing with fractional shares offers a new way to build diverse portfolios at a low cost.
Direct indexing is a method to reproduce mutual funds or ETFs, but instead of owning a share of the fund, you actually own the underlying stock in each company. Owning the shares yourself gives you greater power of decision. You can now be much more restrictive in the companies you want to add or exclude. With more and more ESG data available (gender, CO2 emissions, bribery cases,...) you can now reach a higher level of granularity and control. Moreover, you now own the stocks yourself which allows you to vote and directly engage with the boards of companies.
Direct indexing is now possible due to fractional shares, which allow investors to buy only a part of a share of a company. This is extremely useful when you are trying to diversify (and again, diversifying is good!). Today, certain stocks might cost you more than $1,000. This is a hefty sum for someone that starts investing. Instead of putting your $1,000 of savings only in Tesla, you can now buy only a fraction and free up some capital for other companies and sectors (renewable, social justice, circular economy).
With Direct indexing and Fractional shares, you can now reproduce the advantages of an ETF without the costs. You can now create a portfolio aligned to your personal values, regardless of how much you have to invest and create truly sustainable savings!
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In our next article, we will talk about ways to assess the sustainability and impact of companies.
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