SRI Study: Marginal Metrics, High Fees, & Promising Performance

Posted on August 14, 2020

• Socially Responsible Investing continues to garner interest; 2019 net fund flows nearly 4X times greater than 2018 flows
• Portfolio Sustainability metrics only slightly improve by choosing conscientious options
• SRI funds are more expensive but promising performance has offset the fee hike thus far

Overview:

Socially Responsible Investing (SRI), also known as Environmental, Social, Governance (ESG) investing, has grown rapidly in popularity in recent years. Asset managers have created new mutual funds and ETFs to support the growing investor demand, and digital advisors continue to roll out SRI-themed options. The basic idea is compelling: use your money to create a positive impact in the world through conscientiously selected investments. However, this space is not without controversy. There are growing concerns about the extent to which social impact is actually being achieved. Additionally, the underlying SRI funds generally have higher fees, which can be significant.

Flows:

According to Morningstar, 2019 net flows into SRI ETFs and mutual funds grew to nearly four times their 2018 net flows. Prior to that, between 2016 and 2018, assets invested in ESG-themed mutual funds grew 34%, according to a study by USSIF.  ESG-themed ETFs grew from $5 billion in cumulative net flows as of the end of 2017 to over $40 billion by the end of 2018, according to EPRF Global.

Metrics:

Robo advisors offer a unique way to track and compare the success of SRI portfolios. Performance of a socially responsible option from a given provider may be compared with the performance of its non-SRI counterpart. Backend Benchmarking does extensive research into robo advisors by opening and funding real accounts at different providers and analyzing their portfolios and performance. We recently conducted a study of SRI-themed portfolios offered by eight leading digital advisors. While we have witnessed a trend of SRI portfolios outperforming their non-SRI peers, the Sustainability Scores of the SRI portfolios leave much to be desired.

To conduct our study, we relied on Morningstar’s Portfolio Sustainability Score of individual funds. With this metric, a lower score corresponds to lower ESG Risks of the underlying companies, meaning that lower scores are better. Morningstar’s guidelines explain that a score above 30 is a High ESG Risk, 20-30 is Medium Risk, and below 20 is Low Risk. Our analysis used a weighted average of the Sustainability Scores for the equity funds in our SRI portfolios and the non-SRI portfolios at the same provider. Lastly, because most of our SRI portfolios only hold SRI-themed funds in the equity portion of the portfolio, this analysis is limited to the equities of each portfolio.

Metric Results:

Across the board, Portfolio Sustainability Scores in SRI-themed accounts were not significantly better than their non-SRI counterparts, with an average difference of only 1.54 points. Of the providers analyzed, the weighted average Sustainability Scores of the equities in the non-SRI portfolios ranged from 24.3 to 25.5, while the SRI equity portfolios ranged from 22.1 to 24.0. Every portfolio, both SRI and non-SRI, fell squarely in the Medium ESG Risk category.

Weighted Average Portfolio Sustainability Score of Equity Portion of Portfolio:

Both TD Ameritrade and Wealthsimple allocated 100% of their SRI portfolios’ equity holdings to ESG-themed funds, which led to 1.9 and 1.2 point improvements to their respective Sustainability Scores but did not move either out of the Medium ESG Risk category.  Other providers, such as Betterment, E*Trade, and Ellevest, only implemented ESG-themed funds for a portion of their SRI portfolios. Betterment allocated 43% of its equity holdings to ESG funds, which resulted in an overall improvement of only 1.5 points in its Sustainability Score.  E*Trade’s and Ellevest’s SRI portfolios allocated 70% and 57%, respectively, resulting in a 1.7 and 1.1 point improvement.

Is it worth the cost?

In our SRI study, we noted that investing in a robo advisor’s SRI portfolio caused a substantial increase in the underlying fund expenses. The average expense ratio for equity funds increased from 0.07% to 0.24%.  Morgan Stanley had the greatest improvement in its ESG score  (2.8 points), but consumers who chose its SRI portfolio realized an increase of 0.45% in the underlying expense ratio of the funds.  Similarly, TD Ameritrade’s SRI portfolio improved its sustainability score by 1.9 points but incurred an increase in fees of 0.28%. There is clearly a premium cost to SRI-themed portfolios despite the marginal difference in ESG impact. 

Weighted Average Expense Ratio of Equity Portion of Portfolio:

Despite the similarity in portfolio composition, there was a significant increase in the expenses of the funds held in the SRI portfolios. Paltry Sustainability Score improvements combined with higher fees raise questions about how much impact signing up for an SRI-themed portfolio has beyond increasing investing costs.  While our analysis shows early signs of SRI portfolios’ outperformance, the question remains:  Are investors being sold SRI portfolios in name only and paying higher fees for nominal improvements in SRI scores?

Promising Performance:

The good news is that in the year-to-date, 1-year, and 2-year periods covered by our analysis, the majority of the equity portions of the SRI portfolios outperformed their non-SRI counterparts. Year-to-date, six of our eight SRI portfolios’ equities outperformed despite their higher fees.

Morgan Stanley SRI and Wealthsimple SRI equities outperformed their counterparts by 4.73% and 3.34%, respectively. When looking at 1-year returns, seven of the eight SRI portfolios outperformed. The average SRI outperformance was by 2.9%. E*Trade, the sole SRI underperformer, was within half a percentage point of its non-SRI version. Notably, all five of our SRI portfolios with a 2-year track record outperformed their non-SRI counterpart by an average of 2.6%.

One contributing factor to this outperformance is that SRI portfolios tend to have less value exposure than their non-SRI counterparts. This has boded well in recent years. For example, overa 1-year period ending June 30, 2020, the Russell 3000 Growth Index returned 21.94%, while the Russell 3000 Value Index returned -9.44%. Many of the providers have a significant value tilt in their non-SRI portfolio, while the SRI portfolios tend to be more evenly distributed between growth and value.

When looking at specific accounts, we see Wealthsimple SRI had significantly more exposure to growth equities than the standard Wealthsimple account, contributing to its more than 6% relative outperformance. Similarly, while both Betterment portfolios are value-tilted, the SRI version has a more modest tilt towards value, helping drive the equities to outperform more than 2% over the 1-year period. Acknowledging the limited time horizon of the analysis, higher net-of-fees performance is an encouraging sign for the industry and may inspire others to embrace sustainable investing themes.

However, the minimal improvements in ESG scores between SRI and non-SRI portfolios is disconcerting for investors. Despite how firms market these portfolios, investors should not blindly assume that they are making a significant positive impact by joining the sustainable investing trend.

Posted in Performance
Tagged Betterment, Ellevest, ESG, ETrade, Fees, Merrill Edge, Morgan Stanley, Performance, SRI, TD Ameritrade, TIAA, Wealthsimple