Two years ago, as more research on sustainable investing began to appear and the number of options that focused on environmental, social, and governance, or ESG, investments continued to grow, we started asking ourselves a question at our firm, Rowling & Associates:
What if we integrated ESG-focused mutual funds into all our client portfolios?
This wasn’t a marketing gimmick. This wasn’t just a reflection of the troubled world we live in and a desire to make a difference. We wanted to know if we could produce better results for our clients.
Instinctively, we believed companies adequately considering ESG factors should be subject to less business risk and thus would produce better risk-adjusted returns over time. We had had an ESG fund buy list for about three years, so we'd been doing our work on the group and understanding what these funds could offer to a portfolio. When we dove deep into the risk statistics on them, they backed up our intuition.
This new focus for us meant we had still more decisions to make about the kinds of funds we wanted for our clients. Should they be dedicated ESG strategies, or should we simply look for regular funds that score well on an ESG basis? Then, how do we communicate the change to clients, some of whom may be skeptical about the idea of sustainable investing?
Considering ESG Ratings Because so many ESG-mandated funds now have accumulated track records, we have more options to pick from than ever before. So, as part of the decision to integrate ESG investing into client portfolios, we made it a goal to find as many suitable ESG-mandated funds as we could.
This was a change for us. When ESG options were limited, we were willing to use funds that had a positive Morningstar Sustainability Rating without having an explicit ESG mandate. In most cases, that is no longer necessary.
Our analysis has two parts: asset allocation and fund selection. Once allocations are completed, we search the entire mutual fund universe to find the best funds that will allow us to properly execute our model portfolios for our clients.
This time, we went through the fund-selection process twice. First, we screened for a non-ESG-oriented mutual fund buy list. After determining this set of funds, we screened for ESG-mandated funds to produce a second buy list.
Our process has long been to discard our previous year’s preferred-fund list and conduct a “start from scratch” search for the best mutual funds. We screen based on the Morningstar Rating for funds (the star rating), five-year track record, and fees below 1%, along with other metrics. After refining the initial list to a workable number, the investment committee performs a deeper qualitative and quantitative study of the remaining funds.
For our ESG list, we also removed the screens related to expense ratios and inception dates as we wanted our screens to be general enough to capture all ESG-oriented funds. (Fee levels would come later in the decision-making process.)
An Improved List We then compared funds in each list. We had to be very careful when comparing these funds to make sure that we were comparing apples to apples. ESG-mandated funds, by virtue of their screens, have an active tilt, even for those tracking an index. And many have concentrated portfolios. In other words, it is hard to compare an ESG-mandated fund to DFA US Core Equity 1 DFEOX or a Vanguard fund--both of which are in the universe of funds we have traditionally lived in.
Not enough bond funds made our cut, so our focus has been on stock funds. We also were unable to find a large-value ESG fund to our liking. Those types of companies don’t correlate well with ESG factors in the current market, which is why many large-cap ESG funds have growth tilts.
Thus, we used Morningstar Direct to create funds of funds, so that we could more accurately compare strategies. For example, when comparing Parnassus Core Equity PRBLX with DFA US Core Equity 1, we realized that Parnassus' portfolio was much more top-heavy, holding fewer mid-cap stocks than did the DFA fund. So, we created a fund of funds that consisted of Parnassus Core Equity, Parnassus Mid-Cap PARMX, and a small-cap value fund weighted in a way that achieved the same style and market-cap profile as the DFA fund. The small-cap fund is not an ESG-mandated fund but has a positive Morningstar Sustainability Rating.
In the end, the basket of ESG-mandated funds had a better performance and risk profile, despite higher expense ratios, than did the traditional model portfolios. Using our 60% equity/40% fixed-income model as a proxy, the ESG portfolio’s five-year annualized standard deviation was reduced to 6.16 from 6.69. Return was higher (5.99% versus 5.84% annualized over the past five years through Nov. 30). Thus, the Sharpe ratio for the ESG-focused portfolio was higher as well at 0.80 versus 0.72.
Convincing Clients For years, we educated our clients on keeping fund expenses low. ESG funds, by nature, are active funds that require a deeper, more specialized bench of analysts. This makes these funds more expensive.
After concluding that ESG funds were the way to go, we created our four model portfolios in Morningstar Direct and realized that they had expense ratios that were about 13 basis points greater than our old models. For our 60%/40% stock/bond portfolio (which is our most used), the expense ratio jumped to 0.57% from 0.44%. In the end, our investment committee agreed that the damped volatility in these portfolios more than made up for the fee increase.
Now, all we had to do was explain this to our clients. We approached clients with complete transparency. We included the proposed changes and increased expense ratio in our quarterly letter and hosted a webinar to explain everything in more detail. Of our roughly 330 households, only a handful questioned our proposed changes--and all but a few (the number was a single digit) signed on once their concerns were addressed.
We started the transition with just qualified accounts. We are going through taxable accounts one at a time. If there are large unrealized gains, we will keep our old funds until the opportunity to sell out of them arises. After that, the transition happens over a period of 10 or so days.
Today, our new clients automatically are invested in a portfolio featuring ESG funds. From day one, they get both the benefit of knowing that their portfolio is better aligned with meeting their financial goals and the knowledge that they are aiming for greater good in the world.
Sheryl Rowling, CPA, is head of rebalancing solutions with Morningstar and principal of Rowling & Associates, an investment advisory firm. She is a part-time columnist and consultant on advisor-focused products for Morningstar, and she continues to actively run her advisory business, from which Morningstar acquired the Total Rebalance Expert software platform in 2015. The opinions expressed in her work are her own and do not necessarily reflect the views of Morningstar.
Lorenzo Sanchez, CFP, is director of wealth management with Rowling & Associates.
This article originally appeared in the first-quarter 2020 issue of Morningstar magazine. Learn how financial professionals can subscribe for free.