Today we are pleased to introduce two new investment strategies that incorporate sustainable investment principles into our portfolio construction process. Along with our Standard strategy, we will now be able to offer a range of investment options to better align client portfolios with client values. This article provides an overview of sustainable investment, outlines our approach to it in the context of our passive management philosophy, describes the key details of our new strategies, and compares relevant portfolio characteristics across all of our strategies.

What is Sustainable Investment?

Investment success has typically been measured in terms of the financial value created for shareholders (e.g. profits and dividends) or debtholders (e.g. cash flows and interest payments), but in recent years there has been increasing desire from a variety of stakeholders to expand this definition. Given the risks associated with issues like climate change and social injustice, some investors prefer more holistic measures of success that consider non-financial impacts on a broader range of stakeholders and the planet.

We define sustainable investment as the process of considering environmental, social, and governance (ESG) factors when making investment decisions, leading to increased longer-term investments into sustainable economic activities and projects. Sustainable investment is an umbrella term covering several different investment approaches that fall between conventional investing and philanthropy on the spectrum of social and financial investment:

Figure 1
The Spectrum of Social and Financial Investment

Awareness of sustainable investment principles and demand for sustainable investment products has increased rapidly over the past few years. According to Morningstar, Canadian assets invested in sustainable mutual funds and exchange-traded funds (ETFs) grew to $33 billion by the end of March 2022, representing a year-over-year growth rate of 43%. Unfortunately, this rapid growth has also led to confusion among investors as new products proliferate without wide agreement on common terminology for how to describe them. For this reason, we have an obligation to clearly explain our approach to sustainable investment and the objectives that each of our new strategies will focus on.

Our Approach to Sustainable Investment

At High Level Wealth Management we strongly believe in the merits of passive investment management – using low-cost exchange-traded funds to track the performance of broadly diversified indices rather than attempting to “beat the market” through active security selection decisions or market timing. However, to the extent that sustainable investment involves making portfolio adjustments that differ from the broad market – underweighting certain industries or companies while overweighting others – we consider it a form of active management. While developing our new strategies, we therefore faced a trade-off between pursuing the potential benefits of sustainable investment and aligning with our passive management philosophy. To manage this friction, we kept the following passive management-inspired goals in mind while evaluating sustainable investment approaches and products:

By its nature, sustainable investment results in deviations from the broad market portfolio. Decisions on the types of adjustments to make and how to apply them should be based on a set of pre-established rules rather than left to the discretion of a portfolio manager.

Historically, a small number of companies have accounted for a large portion of the total market return. All else being equal, the fewer holdings in a portfolio, the lower the probability that the portfolio will have exposure to the “next big thing.” Although sustainable investment reduces exposure to certain industries or companies, our preference is for funds that do so while attempting to preserve broad market coverage and diversification.

Investing in sustainable products typically involves higher costs compared to the broad market. Any evaluation must therefore take into account estimates of fund management fees, fund operating costs, and the bid-ask spread incurred when buying or selling products.

Evaluating the universe of sustainable investment products in the context of these goals, we quickly determined that one of the approaches to sustainable investment from Figure 1 – Impact Investing – would not be practical to implement. First, the objective of impact investing – targeting investments to generate positive social or environmental impacts – does not lend itself to a rules-based indexing methodology. Instead, impact investing requires the judgement of a skilled fund manager able to identify, often based on intangible/qualitative factors, the companies that best meet the impact fund’s objectives. Second, since impact funds tend to target a specific theme (e.g. renewable energy, clean water, or gender equality) they typically have quite concentrated portfolios. Third, given the reliance on human and technological resources to research and analyze individual companies and industries, impact funds tend to have high product costs.

While we decided against developing an impact investing strategy, we determined that the other two approaches to sustainable investment from Figure 1 – ESG Integration and Socially Responsible Investing – can be implemented in a manner that is consistent with our passive management-inspired goals. We describe our two new strategies next.

The ESG Optimized Strategy

Our ESG Optimized strategy aligns with the ESG Integration approach from Figure 1, with an objective of assessing financial risks and opportunities related to environmental, social, and governance issues as a core component of building a portfolio. The ESG Optimized strategy provides exposure to companies with high ESG ratings while maintaining market-like risk and return characteristics, making it ideal for investors seeking some consideration of ESG factors in their portfolio without deviating too far from the broad market portfolio.

The majority of the ESG Optimized strategy’s underlying exchange-traded funds currently track the MSCI Extended ESG Focus Indices (for equity) and the Bloomberg MSCI ESG Focus Indices (for fixed income). The securities selected for inclusion in these indices are determined using the following rules-based methodology:

The ESG Optimized strategy eliminates exposure to securities with business involvement in certain industries. Exclusions are determined by filtering/screening a list of potential investments to identify companies with the following business involvements:

  • civilian firearms
  • controversial military weapons
  • tobacco

Outside of Canada, the following industries are also excluded:

  • thermal coal
  • oil sands

The indices tracked by the ESG Optimized strategy have mechanisms in place to track and measure business controversies, which are events that cause reputational damage and highlight a firm’s lack of preparedness and/or inability to manage emerging events and risks.

The ESG Optimized strategy currently screens out any securities with a Controversy Score of 0 (i.e. Very Severe Controversy).

Securities without an ESG rating or controversy score are also screened out.

To ensure that the portfolio characteristics and investment returns of the ESG Optimized strategy do not deviate too dramatically from the broad market, a set of constraints are put in place. The constraints limit the degree of overweighting or underweighting applied to individual sectors, countries, or constituents relative to their weighting in the broad market.

Equity Constraints:

Return deviation target: 1.0% per year vs. broad market
Sector/country weights: +/- 5% vs. broad market
Individual constituent weight: +/- 2% vs. broad market

Fixed Income Constaints:

Return deviation target: 0.1% per year vs. broad market
Sector/country weights: +/- 2% vs. broad market
Individual constituent weight: +/- 1% vs. broad market

Once securities subject to exclusions and controversies have been screened out, the indices tracked by the ESG Optimized strategy are constructed using portfolio optimization software. The optimization process aims to maximize exposure to higher ESG scores subject to meeting the index optimization constraints mentioned in the previous step and with consideration for the amount of portfolio turnover that will be generated.

The indices tracked by the ESG Optimized strategy will typically rebalance their portfolio weightings on a quarterly basis. During each rebalancing, changes to the ESG data of each security are reviewed and the portfolio optimization process is repeated.

Given the sector-, country-, and constituent-level constraints applied by the index methodologies, it is important to understand that the ESG Optimized strategy doesn’t exclude entire industries and will have exposure to securities that don’t meet the typical definition of sustainable. For example, the ESG Optimized strategy mainstains exposure to the energy and utility sectors including oil sands producers and pipeline operators; however, the ESG Optimized strategy should result in an overall portfolio that is tilted toward companies with higher ESG ratings compared to our Standard strategy.

If you would prefer to more closely align your investments with your values by excluding entire industries from your portfolio, our second sustainable investment strategy may be more appropriate.

The Socially Responsible Strategy

Our Socially Responsible strategy aligns with the Values-Based approach from Figure 1, with an objective of aligning investments to ethical values by expressing preferences for specific industries and companies. The Socially Responsible strategy provides exposure to companies with high ESG ratings while extensively screening out controversial industries that may pose elevated headline and ESG risks, making it ideal for investors with very high conviction on ESG risks/opportunities or investors with a strong focus on climate-related risks.

The Socially Responsible strategy’s underlying exchange-traded funds currently track a variety of indices including the MSCI Choice ESG Screened Indices, the FTSE US All Cap Choice Index, the MSCI ACWI Climate Paris Aligned Index, and the Bloomberg MSCI Choice ESG Screened Indices. While the security selection process used by each index varies, they all utilize rules-based methodologies that can be generalized as follows:

The Socially Responsible strategy eliminates exposure to securities with business involvement in a broader range of industries. While the specific list of excluded industries varies by index, common exclusions include:

  • adult entertainment
  • alcohol
  • gambling
  • tobacco and cannabis
  • genetic engineering
  • civilian firearms
  • controversial military weapons
  • conventional military weapons
  • nuclear weapons
  • for-profit prisons
  • predatory lending
  • palm oil
  • nuclear power

The Socially Responsible strategy also screens out securities with an industry tie to fossil fuels (e.g. thermal coal, oil and gas, oil sands).

The indices tracked by the Socially Responsible strategy have mechanisms in place to track and measure business controversies, which are events that cause reputational damage and highlight a firm’s lack of preparedness and/or inability to manage emerging events and risks.

Individual index methodologies differ, but will generally evaluate whether companies are involved in serious ESG controversies consistent with international norms represented by the United Nations Declaration of Human Rights, the International Labor Organization Declaration on Fundamental Principles and Rights at Work, and the United Nations Global Compact Principles.

MSCI ESG Ratings aim to measure a company’s management of financially relevant ESG risks and opportunities. They use a rules-based methodology to identify industry leaders and laggards according to their exposure to ESG risks and how well they manage those risks relative to peers. ESG ratings range from leader (AAA, AA), to average (A, BBB, BB) to laggard (B, CCC).

While the indices tracked by the Socially Responsible strategy have various methodologies, many include a minimum ESG rating requirement (e.g. ESG rating of BBB or higher). Securities with ESG ratings below the minimum, or securities without an ESG rating, are excluded from the index.

The indices tracked by the Socially Responsible strategy typically rebalance their portfolio weightings on a quarterly basis, based on constituent market capitalizations. This differs from the ESG Optimized strategy which relies on portfolio optimization software to set portfolio weightings in a way that maximizes ESG score subject to a set of constraints.

To improve portfolio diversification, some indices tracked by the Socially Responsible strategy will also place a cap (e.g. 5% or 10%) on the maximum weight for individual constituents.

Unlike the ESG Optimized strategy, the Socially Responsible strategy does not in any way constrain portfolio adjustments applied at the sector-, country-, or constituent-level, which may result in larger return deviations from the broad market portfolio. This is a necessary trade-off when applying more extensive screening to better align the investment portfolio with investor values, so it is up to each investor to decide if they are comfortable with the possibility of larger return deviations (also referred to as “tracking error”).

Comparing Investment Strategies

With a general understanding of our sustainable investment strategies you may now be wondering how they compare to each other and our Standard strategy. The following tables and charts present characteristics for our three investment strategies using our Risk 6 model portfolio (60% equity / 40% fixed income) as a representative example.

Conclusion

While capitalism has proven to be an effective system for allocating scarce financial resources to investment opportunities, it has not been particularly well-suited for addressing issues linked to environmental, social, and governance factors. As such, we don’t view sustainable investment as a panacea for solving the many complex issues currently facing society, but rather a small step in the right direction. By considering more than just profits when constructing investment portfolios, our new sustainable strategies allow investors to broaden their definition of investment success and to better align their investments with their values.

If you are interested in the topic of sustainable investment, we encourage you to discuss your preferences with your advisor and complete our new investment values questionnaire. Over the course of the next year, we will be discussing sustainable investment with each of our clients during suitability assessment review meetings, but if this topic is something you are passionate about, we would be happy to have a discussion with you sooner.

Additional Resources

For those that are interested in learning more about the topic of sustainable investment, the following list of resources may be helpful: