How to Build an ESG Portfolio

Susan Dziubinski: Hi, I'm Susan Dziubinski from Morningstar.com. Morningstar director of personal finance, Christine Benz, recently introduced a series of model portfolios featuring mutual funds and ETFs with an ESG focus--ESG standing for environmental, social, and governance. She's here with me to discuss how investors can put together their own ESG portfolios if they're so inclined.

Christine, thanks for joining us today.

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

Dziubinski: Now, first, let's step back. How many portfolios have you created, and what are they?

Benz: There are 12 portfolios altogether. Six of them are geared toward people who are already retired. So, there are three mutual fund retiree portfolios, aggressive, moderate, and conservative. There are three ETF portfolios for retirees as well--also aggressive, moderate and, conservative. Then we also have counterparts for people who are still accumulating assets for retirement. So, again, we have portfolios that are composed of exchange-traded funds, as well as portfolios that are composed of traditional mutual funds.

Dziubinski: Great. Now, the first step in putting together a portfolio, whether it's ESG or not, is setting an asset allocation. So, how did you go about doing that?

Benz: I relied on our Morningstar Lifetime Allocation indexes to kind of lay the groundwork for the asset allocations of the portfolios. I would urge investors who are putting together their own portfolios to either get some professional guidance here from a financial advisor or maybe--if they're not working with an advisor--maybe lean on some professionally managed allocation. So, look at a target date that's geared toward someone with your same expected retirement date just to see what they are mapping out in terms of asset allocations. In retirement, I like the idea of people customizing their own asset allocation, really depending on how much they expect to be spending from their portfolio.

So, as you know, Susan, I'm a big believer in this Bucket approach to retirement portfolio planning, where you use your expected portfolio withdrawals to guide how much to hold in each asset class. So, with near-term expenditures, you'd want to keep that money really safe in cash, and then you step out on the risk spectrum from there. I've written about this topic on Morningstar.com before, but I think it is very individual-specific. This is a spot to get some help from a financial advisor. But definitely think about your own portfolio spending plan as well as your own risk tolerance. If you are someone who is extremely risk averse, I think you'd probably want to hold more in cash and bonds than if you're someone who feels comfortable riding out periodic bouts of market volatility.

Dziubinski: Once you have that asset-allocation step taken care of, the next is choosing your holdings. And you've said that one thing you need to figure out if you want to be investing in ESG fashion is to figure out: How ESG do you want to be? What do you mean by that?

Benz: This was really a learning process for me, Susan, from the standpoint of understanding how some of these ESG products are put together. And one thing to know is that some funds are willing to put up with a lot of idiosyncratic risk, whether sector bets or heavy individual stock positions in the interest of having a very ESG-friendly portfolio. So, they don't want to own, say, any companies that are producing fossil fuels, that's just an example, which might give them very divergent sector positioning relative to the broad market. Other funds, especially you see this in the index fund space, want to more or less reduce their tracking error relative to a market benchmark. So, they kind of want to keep performance in line with that market benchmark. But they at the same time want to have some ESG characteristics as well. So, just I would say get clear on how you are threading that needle. It's really a matter for each of ourselves to decide.

In the case of the model portfolios, I set up the ETF portfolios to have limited tracking error, meaning that they're going to deliver kind of indexlike performance, whereas the mutual fund portfolios are composed largely of actively managed funds. Those are more ESG-y portfolios, and I would expect them to have higher tracking error relative to the benchmark. I worked with our colleague, Jon Hale, who is Morningstar's head of sustainability research, to help figure out how to populate these portfolios. In the mutual fund portfolios, we were able to use some of the funds that Jon respects most from the standpoint of their ESG criteria. So, one firm that we used is Parnassus, which has long been a big name in this space. That's an example of a firm that Jon thinks highly of in terms of their investment acumen as well as their ESG characteristics.

Dziubinski: What are some of the things that ESG investors should be looking for in an equity fund?

Benz: I think a key fork in the road that you'll face whether looking at equity or fixed-income holdings is that you need to decide whether you want to be in a passively managed product or in an actively managed product. So, that's the same fork in the road that really any investor faces. Think about what you want there. Of course, with the passively managed product, you do have the lower costs at, typically, a company index funds and ETFs. But you might have a little less of that intentionality that can accompany some of the actively managed ESG products. So, think through that issue. And again, it's pretty individual-specific to decide. You definitely want to focus on costs. So, even though ESG fund costs have come down quite a bit, there are still some higher-cost products out there. So, be paying attention to that as well.

Dziubinski: And on the bond side of things, there are fewer funds to choose among it seems like, even though that space does seem to be growing.

Benz: It does. We've seen a lot of new launches in the bond area. Pimco has some funds. Some of the big players are engaging with ESG products. So, there are more choices. But you're right, you are, I would say, less flexible in terms of your choices. You won't be able to cover every nook and cranny of the bond market with ESG bond-fund choices. There are definitely some good-quality core products out there. There are index funds as well as active products. Another thing to think about is, there might be some exposures you'd want in the portfolio such as inflation-protected bonds, which are something that I typically include in my in-retirement portfolios.

One thing to think about is that in many bond ESG products, U.S. government bonds actually make it through the funnel. So, if you're putting together a holistic portfolio and you want your bond portfolio to be encompassing, by that logic, I think you could realistically own a stand-alone Treasury Inflation-Protected Securities fund, for example, if you wanted to, because those are government bonds. But I would watch that space because I would expect to see more and more products coming online.

Here, though, costs are even more crucial, because as I was winnowing through this universe, I did see some funds with terribly high costs. And when we're looking at bond yields today of like, 2%, do you really want to be ceding, say, 1% of your 2% return that you might earn to costs? I don't think so. So, you need to be careful that you're not sacrificing too much in an effort to build an ESG-friendly portfolio.

Dziubinski: And then from a portfolio-construction standpoint, are there things that you'd be leaving out--parts of the market or types of investments--if you were pursuing sort of this all-ESG approach?

Benz: Not necessarily. There might be a few categories, sort of, the niche categories. A commodities tracker, for example, or precious metals; you probably, at this point, cannot delve into ESG-specific products in that space. I think that's OK. It didn't really limit me in terms of putting together the portfolios. You'll also find fewer smaller bore equity funds. So, you won't necessarily find--well, you might be able to find an ESG small-growth fund, but you won't have many choices. So, for people who really like to micromanage the equity exposures in their portfolios, that probably is not going to be an easy task currently either. But again, I don't think that's the worst thing in the world.

Dziubinski: Right. Right. Christine, thank you so much for your time today.

Benz: Thank you, Susan.

Dziubinski: I'm Susan Dziubinski from Morningstar. Thanks for tuning in.