How to Build an ESG Portfolio

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Interest in mutual funds and ETFs that focus on environmental, social, and governance issues has exploded and so have the choices. Joining me today to talk about the things you should keep in mind as you're building an ESG portfolio is Christine Benz. Christine is Morningstar's Director of Personal Finance.Hi, Christine. Thanks for joining us today.

Christine Benz: Hi, Susan. It's great to be here.

Dziubinski: So, let's start off by talking about the ESG model portfolios that you've built on Morningstar.com. How many of them are there and how are they different from each other?

Benz: Well, there are 12 altogether, and there are six what we call "bucket portfolios." Those are geared toward people who are in retirement, so who are actively drawing upon their portfolios. Within those bucket portfolios, we have three ETF, exchange-traded fund portfolios, and three mutual fund portfolios. And then, there are six portfolios that are geared toward people who are still in the accumulation phase of their retirement careers, so they're saving for retirement and there, again, we have three ETF portfolios and three mutual fund portfolios. But the basic idea was to showcase what we think are sound asset-allocation structures for portfolios as well as some of our favorite ESG funds and ETFs.

Dziubinski: Now, if an investor does want to assemble a portfolio of ESG-focused mutual funds and ETFs, what's the first step?

Benz: I think the first step is just thinking about how deeply you want to get into this. So, for some investors, it might be as simple as just adding one ESG fund, kind of dipping a toe into the ESG landscape. For other investors, they might look at this and say, this is an idea that I really want to embrace wholeheartedly. I would like all of my holdings, or as closely to that as I can get to be ESG funds. So, do some soul searching around that. There's no one right answer. And you may be limited if, for example, most of your assets are within your 401(k) plan and there is no ESG fund, well, then you're limited in terms of how ESG-y your portfolio can get. You may have to do your ESG investing through an IRA. So, just give a little bit of thought to that. I see that as the starting point.

Dziubinski: And then, you also say that before building a portfolio of ESG funds or ETFs, you should think about the type of ESG focus that you're really interested in. Talk a little bit about that.

Benz: Right. It's interesting, this landscape has evolved so rapidly, Susan, where 20 years ago, the ESG landscape was mainly made up of funds that excluded various industries, whether energy companies or gun makers or alcohol companies, whatever it might be. Now, we have just a really broad gradation of ESG fund types. And I would rate them as on kind of a spectrum where you have some that are what I would call sort of ESG light where they're looking to own very broad sector diversification. They're looking to behave a lot like the broad market except excluding some of the more objectionable sorts of companies. And then, on the other end of the spectrum, you would have companies that are much more ESG-forward, where that is front and center in their process and it very much affects the makeup of the portfolio where the portfolio might have more-significant tracking error relative to the broad market in exchange for a heavier ESG emphasis, a more-pure ESG emphasis. So, give some thought to where you want to land on the spectrum. Are you okay with owning sort of the companies that are in every industry, but are the least-objectionable companies in those industries? Or are you looking for more of a pure ESG portfolio? And there are holdings that you can use with either approach.

Dziubinski: Now, a key consideration when building any portfolio, ESG or otherwise, is to take into account your goal and then matching that an asset allocation that's appropriate for that goal. How does an investor do that?

Benz: Right. And this is not an ESG part of the process. This would correspond or would relate to anyone who is building any type of portfolio. But I think that that's the main way to think about how to put together a portfolio, is thinking about your proximity to spending that money for whatever goal that you're saving for. So, obviously, if you are saving for goals that are close at hand, you want to have more safe investments in that portfolio, and you'd want to gradually tip into safer investments as that goal date draws near. If you are a 30-year-old saving for retirement, well, obviously you have a lot more room to tolerate fluctuations in the portfolio. You want a more-aggressive asset mix most likely because you want to try to reach for the highest return potential that you can get. So, I think that that's a key starting point when investors are thinking about building a portfolio composed of ESG funds or any type of funds. Think about your time horizon and that in turn can inform how much safety you need in that portfolio.

Dziubinski: And Christine, the ESG landscape has really exploded in the past several years, as you pointed out earlier. Are there still pockets of the market where there maybe aren't great ESG options?

Benz: There are potentially a few, Susan, but there has been such a rapid rollout of products in this space that really it's possible to cover the major asset classes with very good quality ESG funds. So, within fixed income, within international equity, obviously, U.S. equity for U.S. investors, that's where you will find the most choices today and you'll be able to really pick and choose. We talked about that gradation. You'll have a lot of latitude to choose the right type of product for you. There are some types of funds though that you will not find an ESG representative of. So, for example, metals, commodities, you probably wouldn't expect to see ESG choices there, and indeed there aren't. But I would say for the most part where people cannot find ESG choices, those are niche categories that you wouldn't want to use in any sort of size within a portfolio in any case.

Dziubinski: Well, Christine, sounds like there's a lot of good news out there for ESG investors and for those looking to dip a toe in ESG waters for the first time.

Benz: Lots of choices.

Dziubinski: Thank you for your time today, Christine. We appreciate it.

Benz: Thank you so much, Susan.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.