What is Impact Investing?
Over the past several years, a growing number of investors have shown an interest in putting their money where their values are, steering them away from certain investments that they view as polluting (e.g., oil and gas companies), endangering (e.g., gun manufacturers or tobacco), or sinful (e.g., casinos or alcohol). Instead, these "impact investors" seek out shares in companies that are green, safety-promoting, and socially-responsible.
It is perhaps no surprise that social-responsible investing (SRI) is especially popular among younger generations, like the millennials. Technology-heavy robo-advisors such as Betterment and Wealthfront have started to offer SRI portfolios to appeal to these investors. Here, we will consider the various ways that a robo-advisor can help with impact investing.
- "Impact investors" seek out shares in companies that are green, safety-promoting, and socially-responsible.
- Many robo-advisors now seek out exchange-traded funds (ETFs) that specialize in SRI and ESG investments and optimize portfolios in such a way as to approximate what modern portfolio theory would otherwise dictate.
- Socially responsible and ESG investing are gaining traction, especially with younger investors who also may be attracted to the technologically-focused investment platforms that robo-advisors provide.
SRI and ESG
There are several frameworks that have arisen to address the desires of impact investing. Environmental, social, and governance (ESG) criteria are a set of standards for a company's operations that socially conscious investors use to screen potential investments. Environmental criteria consider how a company performs as a steward of nature. Social criteria examine how it manages relationships with employees, suppliers, customers, and the communities where it operates. Governance deals with a company's leadership, executive pay, audits, internal controls, and shareholder rights.
Socially responsible investing, also known as social investment, is an investment that is considered socially responsible due to the nature of the business the company conducts. Socially responsible investments ignore companies that produce or sell addictive substances (like alcohol, gambling, and tobacco) in favor of seeking out companies that are engaged in social justice, environmental sustainability, and alternative energy/clean technology efforts.
There are two inherent goals of socially responsible investing: social impact and financial gain. The two do not necessarily have to go hand in hand; just because an investment touts itself as socially responsible doesn't mean that it will provide investors with a good return, while the promise of a good return is far from an assurance that the nature of the company involved is socially conscious. An investor must still assess the financial outlook of the investment while trying to gauge its social value.
According to a recent report from the U.S. SIF Foundation, investors held $11.6 trillion in assets chosen according to socially-responsible criteria at the beginning of 2018, up from $8.1 trillion just two years earlier.
Impact Investing with Robo-Advisors
Robo-advisors are algorithmic investment platforms that automate and optimize portfolio choices for individual investors with low costs and minimal human involvement. Traditionally, robo-advisors follow the logic of modern portfolio theory (MPT) to optimize a diversified portfolio across several asset classes and a philosophy that indexing is the best strategy for most investors. Indexing, however, implies that every stock in an index be held at its given weight in that index. Therefore, index investors will undoubtedly end up holding shares in companies that are not SRI or ESG-friendly.
To solve this issue, many robo-advisors now seek out exchange-traded funds (ETFs) that specialize in SRI and ESG investments and optimize portfolios in such a way as to approximate what modern portfolio theory would otherwise dictate. A robo-advisor can improve SRI investing for many investors that are doing it themselves: Some investors buy SRI funds that carry high management fees or sales loads, while robo-advisors seek out low-cost ETFs. Others screen for SRI stocks in such a way that they forgo the benefits of proper diversification against risk. These investors pick their own basket of SRI stocks, which can be a challenging and time-intensive approach. Robo-advisors can also automate portfolio rebalancing and engage in tax-loss harvesting to minimize tax exposure for investors.
What SRI Approaches do Robo-Advisors Use?
Each robo-advisor approaches SRI and ESG portfolio construction a little bit differently. Some platforms, like Earthfolio, only have SRI investment options and nothing else. Here, we will briefly describe some of the strategies used by popular broad-based robo-advisors:
Betterment seeks out SRI funds for U.S. large-cap stocks and emerging markets stocks only. According to their website, "Other asset classes, such as value, small-cap, and international stocks and bonds, are not replaced with an SRI alternative in our portfolio either because an acceptable alternative doesn't yet exist or because the respective fund's fees or liquidity levels make for a prohibitively high cost to you, our customers." Therefore the stocks, but not bonds, of companies like Exxon Mobile, Chevron, and Philip Morris may be excluded.
The ETFs that Betterment uses in their SRI portfolios are DSI, SUSA, and ESGE.
Unlike Betterment, which identifies SRI ETFs, Wealthfront allows certain users to instead restrict which companies they do not want to invest in. According to the company's website, "If you currently qualify for Stock-level Tax-Loss Harvesting or Smart Beta, you can tell us which companies you do not wish to invest in using the restrictions list in your settings."
Personal Capital is intended for higher-net-worth individuals, with a minimum opening balance of $100,000 to get started. For those customers, Personal Capital does offer SRI portfolio options. Similar to Betterment, the ESG components only apply to ETFs chosen for U.S. equity components of their portfolios. The rest of the asset class components rely on traditional ETFs and funds. But what is unique, however, is that Personal Capital itself selects the stocks it deems most appropriate and earn the highest ESG scores for that equity component, which they claim provides a higher level of "best-in-class" ESG stocks than ETFs like DSI.
Wealthsimple takes a more complete approach to SRI investing, utilize ESG-optimized ETFs for both equities and fixed income components and splitting these up by criteria. For instance, they use one ETF that invests in global stocks that have small carbon footprints and another ETF that specializes in companies with a high degree of gender diversity in their leadership. On the bonds side, instead of corporate bonds, they seek out municipal bonds issued by local or state governments that have SRI initiatives and government-issued bonds that support affordable housing.
The ETFs Wealthsimple uses include CRBN, PZD, SHE, DSI, GNMA, and BAB.
Ellevest is the robo-advisor specifically intended for female investors. It is no surprise then that Ellevest includes funds that support growing small businesses owned by women and other underrepresented populations in its impact portfolios—in addition to more traditional ESG-focused ETFs.
The Bottom Line
Socially responsible and ESG investing are gaining traction, especially with younger investors who also may be attracted to the technologically-focused investment platforms that robo-advisors provide. Several robo-advisors now offer socially-responsible or impact investing portfolios alongside their more traditional diversified index portfolios. While we only profile a few here, many more robo-advisors are beginning to include ESG funds in order to meet the demands of their users.