TABLE OF CONTENTS
- How do we define SRI?
- The Challenges of SRI Portfolio Construction
- How is Betterment’s Broad Impact portfolio constructed?
- How socially responsible is the SRI portfolio?
- Should we expect any difference in an SRI portfolio’s performance?
- Climate Impact Portfolio
- Social Impact Portfolio
In today’s landscape, design and ongoing management of a values-driven investing strategy continues to face many challenges. Even the relevant terminology is in flux. Socially Responsible Investing (SRI), the most historically established term used to describe the integration of values into one’s investments, is today often used interchangeably with Environmental, Social and Governance (ESG), which strictly speaking, is more of an implementation, than the broad concept. Industry professionals are increasingly consolidating on “sustainable investing” as the umbrella designation of choice, though the public at large often associates that term with a narrower environmental focus, further adding to the confusion.
Betterment first made a values-driven portfolio available to our customers in 2017, under the SRI label. As we expand our offerings in 2020, we maintain SRI as the umbrella term for the category, including throughout this paper. That there remains no agreed-upon terminology which is broadly understood by retail investors, is as good a symbol as any that this is still an emerging field, with surging demand a relatively recent phenomenon.
That the values-driven investing landscape is expected to continue evolving, both in terms of superficial labels, and in substance, continues to inform the core of Betterment’s aspirational approach to SRI. It is as much a process, as it is a product—designed to be iterated on over time, without sacrificing the core principles of our advice: balanced cost and proper global diversification. Despite the nascent state of SRI, Betterment’s portfolios represent a diversified, low-cost solution that will be continually improved upon as costs drop, more and better data emerges, and as a result, the availability of SRI funds broadens (in this paper, “funds” refer to ETFs, and “SRI funds” refer to ETFs screened for some form of ESG criteria).
In developing our SRI portfolios, we had to research, analyze, and ultimately answer five important questions:
- How should we define SRI for a portfolio?
- What are the challenges for implementing SRI today?
- Which SRI funds are among the best for an effective portfolio?
- How should we assess the “social responsibility” of an SRI portfolio?
- Should we expect any difference in an SRI portfolio’s performance?
The resulting answers to these questions, explained in the sections that follow as well as in our SRI disclosures, informed how we created the Betterment SRI portfolios for our customers, including legacy versions of the SRI portfolios. In the first five sections we answer these questions both generally for all our SRI portfolios and with respect to Betterment’s Broad Impact offering, which focuses on investment options that consider broad social responsibility factors. Betterment also offers two additional, more focused SRI portfolio options, a Social Impact SRI portfolio (focused on social governance criteria) and a Climate Impact SRI portfolio (focused on climate-conscious investments). These strategies are further elaborated on in Sections VI and VII.
I. How do we define SRI?
Our approach to SRI has two fundamental dimensions:
- Reducing exposure to companies involved in unsustainable activities and environmental, social, or governmental controversies.
- Increasing investments in companies that work to address solutions for core environmental and social challenges in measurable ways.
We chose to define our SRI approach using a set of industry criteria known as “ESG”, which stands for Environmental, Social and Governance.
Though SRI and ESG are often used interchangeably in general financial literature, experts will point out that there is a clear distinction between how each term is defined.
SRI is the traditional name for the broad concept of values-driven investing (many experts now favor “sustainable investing” as the name for the entire category). ESG refers specifically to the quantifiable dimensions of a company’s standing along each of its three components. In our SRI portfolios, we use ESG factors to define and score the degree to which our portfolio is socially responsible.
Using ESG Factors to Define an SRI Approach
A significant and obvious aspect of improving a portfolio’s ESG score is reducing exposure to companies that engage in unsustainable activities in your investment portfolio. Companies can be considered undesirable because their businesses do not align with specific values—e.g. selling tobacco, military weapons, or civilian firearms.
Other companies may be undesirable because they have been involved in recent and ongoing ESG controversies and have yet to make amends in a meaningful way.
ESG controversies include:
- Environmental controversies related to energy and climate change, land use, biodiversity, toxic spills and releases, water stress, and/or operational waste. A recent example is the BP (Deepwater Horizon) oil spill from 2010.
- Corporate governance controversies involving fraud, bribery, and controversial investments. A recent example is Wells Fargo’s recent controversy where the company may have created as many as 3.5 million fraudulent accounts in the last 15 years.
- Labor controversies like discrimination and other violations of International Labor Organization standards. For example, the class action lawsuit against Sterling Jewelers, alleging gender discrimination and sexual harassment within the company.
- Customer controversies involving anticompetitive practices, privacy and data security, and product safety. Remember the massive Yahoo data security breach from 2016 where 500 million user accounts were hacked?
SRI is about more than just adjusting your portfolio to minimize companies with a poor social impact. Based on the framework of MSCI, a leading provider of ESG data and analytics, a socially responsible investment approach also emphasizes the inclusion of companies that have a high overall ESG score, which represents an aggregation of scores for multiple thematic issues across E, S, and G pillars as shown in Table 1 below.
Table 1. A Broad Set of Criteria Across E, S and G pillars
|3 Pillars||10 Themes||37 Key ESG Issues|
|Environment||Climate Change||Carbon Emissions
Product Carbon Footprint
|Natural Resources||Water Stress
Biodiversity & Land Use
|Pollution & Waste||Toxic Emissions & Waste
Packaging Material & Waste
|Environmental Opportunities||Opportunities in Clean Technology
Opportunities in Renewable Energy
Opportunities in Green Building
|Social||Human Capital||Labor Management
Human Capital Development
Health & Safety
Supply Chain Labor Standards
|Product Liability||Product Safety & Quality
Privacy & Data Security
Financial Product Safety
Health & Demographic Risk
|Stakeholder Opposition||Controversial Sourcing|
|Social Opportunities||Access to Communications
Access to Health Care
Access to Finance
Opportunities in Nutrition & Health
|Corporate Behavior||Business Ethics
Corruption & Instability
Financial System Instability
|*Board, Ownership, Pay, and Accounting carry weight in the ESG Rating model for all companies. Currently, they contribute to the Corporate Governance score directly and 0-10 sub-scores are not available.
Source: MSCI Ratings Methodology
II. The Challenges of SRI Portfolio Construction
Although using ESG factors to select portfolio funds may sound like a brilliantly straightforward, quantitative approach to constructing a portfolio, unfortunately, in today’s market, there are a number of limitations that plague the process of executing SRI. In spite of these limitations, we still strive to maximize the expression of your SRI values with some of the best available investing tools.
For Betterment, three limitations had a large influence on our overall approach to building an SRI portfolio:
1. Poor quality data underlying ESG scoring.
Because SRI is still gaining traction, data for constructing ESG scores are at a nascent stage of development. There are no uniform standards for data quality yet.
Some companies disclose data on the various ESG metrics, others do not. And companies that do disclose their data may do so in inconsistent ways. As a result, ESG metrics may not necessarily capture the desired concepts and ideals with 100% accuracy.
In order to standardize the process of assessing companies’ social responsibility practices, Betterment uses ESG factor scores from MSCI, an industry-leading provider of financial data and ESG analytics that has served the financial industry for more than 40 years. MSCI collects data from multiple sources, company disclosures, and over 1,600 media sources monitored daily. They also employ a robust monitoring and data quality review process. See the MSCI ESG Fund Ratings Executive Summary for more detail. By adopting MSCI’s framework for calculating ESG metrics, we’re putting our best foot forward toward assuring the data is as accurate as currently possible.
2. Many existing SRI offerings in the market have serious shortcomings.
Many SRI offerings today:
- Sacrifice sufficient diversification appropriate for investors who seek market returns.
- Allocate based on competing ESG issues and themes, scattering the focus and reducing the effectiveness of the portfolio.
Some solutions do not use a diversified range of asset classes—for example, holding mostly or entirely US Large Cap funds–or invest only in a handful of individual stocks within an asset class. At Betterment, diversification is a fundamental pillar of our advice, and we do not believe it’s in our customers’ best interests to offer them an under-diversified portfolio. Our approach has the advantage of maintaining global diversification at a relatively low cost.
In the second case, some approaches to SRI may seek to address a broad set of values by using a combination of more focused, single issue funds as the core of the portfolio (for example, an environmentally focused ETF, a social equity focused ETF, etc).
Some companies rank highly with respect to their environmental practices, but poorly on another, like board diversity, or vice versa. Rather than doubling down on multiple areas of impact, combining funds with a distinct focus can instead dilute each intent, by increasing the likelihood of offsetting positions in the same asset class.
Betterment’s SRI portfolios do not sacrifice global diversification and the Broad Impact portfolio, by using the ESG Quality Score, seeks to balance each of the three dimensions of ESG without diluting different dimensions of social responsibility. The ESG Quality Score will tilt towards companies that rate highly on multiple dimensions as opposed to just one. With our Social Impact portfolio, we sharpen the focus on social equity with partial allocations to gender and racial diversity focused funds, with US Equities only, which is the only asset class today where that focus is attainable. With our Climate Impact portfolio, where a broader set of options are available, we sharpen the focus on controlling carbon emissions and fostering green solutions across the entire global portfolio.
3. Integrating values into an ETF portfolio may not always meet every investor’s expectations, though it offers unique advantage
For investors who prioritize an absolute exclusion of specific types of companies above all else, the ESG Scoring approach will inevitably fall short of expectations. For example, many of the largest ESG funds focused on US Large Cap stocks include some energy companies that engage in oil and natural gas exploration, like Hess. While Hess might rate relatively poorly along the “E” pillar of ESG, it could still rate highly in terms of the “S” and the “G.” Furthermore, maintaining our core principle of global diversification, to ensure both domestic and international bond exposure, we’re still allocating to some funds without an ESG mandate, until satisfactory solutions are available within those asset classes.
There is a view across the asset management industry, with a certainty approaching conventional wisdom, that only unbundling ETFs and holding the underlying securities directly, will offer the general public the ability to fully align their values with their investments. This approach is increasingly described as “direct indexing”, though the practice of tracking an index by trading the individual stocks in so-called SMAs (separately managed accounts) is decades old.
An established index might serve as a starting point, after which, an investor’s specific bundle of preferences can be applied. This is particularly effective with respect to absolute exclusions. While ESG index providers such as MSCI or Morningstar might deem some particular company as worthy of inclusion, direct indexing offers the ability to override it.
The hyper-personalization of direct indexing no doubt has its applications, but for most investors, an ETF-based approach to values-driven investing offers some unique advantages. We’ve heard from our customers that while knowing that they have personally limited or eliminated exposure to certain companies is important, it also matters to them that their investing choices contribute towards driving positive change.
Investing in ETFs with ESG mandates maximizes the external impact of such choices. Publicly traded corporations employ entire Investor Relations teams, whose jobs include monitoring how their stock is faring across widely adopted indexes. Just as a company’s inclusion into the S&P 500 typically results in a price jump, a downgrade or outright exclusion from an influential ESG index is highly visible, and thus a cause for concern for a company’s management team.
But an index is only as influential as the volume of assets that track it, and no assets are as easily counted, and as directly attributable to that index, as those invested in publicly traded funds. Tracking a values-driven index by buying and selling stocks in your personal account allows for additional customization, but when you invest in a fund that tracks that values-driven index, you are pooling your values with those of others in one of the most effective ways, empowering that index, and providing leverage to those who actively engage with companies, pushing them to improve their ESG metrics. Banding together with like-minded investors through a fund, amplifies your voice on issues that matter to you—like a form of collective bargaining.
Furthermore, as more dollars flow into ETFs with ESG mandates, issuers are responding with more specialized offerings, allowing for ever more customization when integrating values into globally diversified ETF portfolios. However, that evolution will take time. This is precisely why we’ve approached our values-driven offering as a journey, not a final destination. We are committed to achieving ever more alignment with our customers’ values over time, through ongoing research tracking the availability of better vehicles, and this approach has been validated.
When we launched our first SRI portfolio in 2017, only the US Large Cap asset class was allocated to an ETF with a sustainable mandate. It was the beginning of a conversation—an invitation to our customers to signal to the investing industry that this matters to them, and that there is demand for high quality values-driven ETFs.
We expected that increased asset flows across the industry into such funds would continue to drive down expense ratios and increase liquidity. Since that original offering, which was the predecessor to what is now our Broad Impact portfolio, we’ve been able to expand the ESG exposure to now also cover Developed Market stocks, Emerging Market stocks, and US High Quality Bonds. And now, sufficient options exist for us to branch out in two different areas of focus—Climate Impact, and Social Impact.
4. Most available SRI-oriented ETFs present liquidity limitations.
In an effort to control the overall cost for SRI investors, a large portion of our research focused on low-cost exchange-traded funds (ETFs) oriented toward SRI. As with any of our portfolios, we aim to help maximize investors’ take-home returns by lowering the costs of the underlying funds.
While SRI-oriented ETFs indeed have relatively low expense ratios compared to SRI mutual funds, our analysis revealed insufficient liquidity in many ETFs currently on the market. Without sufficient liquidity, every execution becomes more expensive, creating a drag on returns. Median daily dollar volume is one way of estimating liquidity. Higher volume on a given asset means that you can quickly buy (sell) more of that asset in the market without driving the price up (down).
Of course, the degree to which you can drive the price up or down with your buying or selling must be treated as a cost that can drag down on your returns. Figures 1 and 2 below put the liquidity issues associated with trading two of the most widely traded SRI ETFs—ESGU and ESGD—into perspective by comparing their liquidity to the liquidity of other ETFs used in Betterment portfolios. Figure 1 compares the most liquid ESG funds, ESGU and ESGD, to the funds in Betterment’s Core portfolio, showing that ESG funds in general are less liquid than traditional market-cap based funds.
Figure 1. In this figure we compare the median daily dollar volumes of the primary funds in the Betterment Core IRA portfolios as of October 2020 against those of ESGD and ESGU. As you can see, every fund that we currently trade in the Betterment portfolios has liquidity that surpasses that of ESGD or ESGU. Data: Factset. Median dollar value traded is measured over the past 45 trading days over the period ending August 25, 2020.
However when compared to other ESG funds in Figure 2, ESGU and ESGD are some of the most liquid ETFs compared to other socially responsible ETF products.
Liquidity is concentrated in the top few SRI funds
Figure 2. ESGU, ESGE, and ESGD are more liquid than other fund options with SRI mandates. Certain SRI-oriented bond ETFs have more recently become liquid enough for inclusion in Betterment’s SRI portfolio, but the vast majority of these funds still lack sufficient liquidity. Data: Factset. Median dollar value traded is measured over the past 45 trading days over the period ending August 25, 2020. Please note that the tickers ESGV, VSGX, SUSC and SUSB in this figure are not included in the Betterment Broad Impact portfolio.
In balancing cost and value for the Broad Impact portfolio, the options were limited to funds that focus on US stocks , Developed Market stocks, Emerging Market stocks, and US High Quality bonds.
Accordingly, ESGU, DSI, SUSA, ESGD, ESGE, and EAGG are the ETFs with SRI mandates that we have selected for the Broad Impact portfolio. They are some of the ETFs with the largest AUM among broadly diversified SRI options, and our investment selection process shows that they have the highest liquidity relative to their size in the Betterment Broad Impact SRI portfolio.
III. How is Betterment’s Broad Impact portfolio constructed?
In 2017, we launched our original SRI portfolio offering, which we’ve been steadily improving over the years. In 2020, we released two additional Impact portfolios and improved our original SRI portfolio, the improved iteration now called our “Broad Impact” portfolio to distinguish it from the new specific focus options, Climate Impact and Social Impact, and the legacy SRI portfolio for those investors who elected not to upgrade their historical version of the SRI portfolio (“legacy SRI portfolio”). For more information about the differences between our Broad Impact portfolio and the legacy SRI portfolio, please see our disclosures.
As we’ve done since 2017, we continue to iterate on our SRI offerings, even if not all the fund products for an ideal portfolio are currently available. Figure 3 shows that we have increased the allocation to funds screened for ESG criteria each year since we launched our initial offering. Today all primary stock ETFs used in our Broad Impact, Climate Impact, and Social Impact portfolios are screened for some ESG criteria.
100% Stock Allocation in the Broad Impact Portfolio Over Time
Figure 3. Calculations by Betterment. Portfolios from 2017-2019 represent Betterment’s original SRI portfolio. The 2020 portfolio represents a 100% stock allocation of Betterment’s Broad Impact portfolio. As additional SRI portfolios were introduced in 2020, Betterment’s SRI portfolio became known as the Broad Impact portfolio. As your portfolio allocation shifts to higher bond allocations, the percentage of your portfolio attributable to SRI funds decreases. Additionally, a 100% stock allocation of the Broad Impact portfolio in a taxable goal with tax loss harvesting enabled may not be comprised of all SRI funds because of the lack of suitable secondary and tertiary SRI tickers in the developed and emerging market stock asset classes.
Betterment has built a Broad Impact portfolio, which focuses on ETFs that rate highly on a scale that considers all three ESG pillars. Broad ESG investing solutions are currently the most liquid, highlighting their popularity amongst investors. Due to this, we will first examine how we created Betterment’s Broad Impact portfolio. Further information on the Social Impact and the Climate Impact portfolios’ construction can be found in Section VI and VII. In order to maintain geographic and asset class diversification and to meet our requirements for lower cost and higher liquidity in all SRI portfolios, we continue to allocate to some funds that do not have SRI mandates, particularly in bond asset classes.
How does the Broad Impact portfolio compare to Betterment’s Core portfolio?
When compared to Betterment’s Core portfolio, there are three main changes. First, in both taxable and tax-deferred portfolios we replace the Core portfolio’s current US stock market exposure with an allocation to a broad ESG US stock market ETF (ESGU). Two other broad ESG US stock market ETFs (DSI and SUSA) serve as the alternative tickers for ESGU, which are utilized by Tax-Loss Harvesting+ (TLH+).
Second, in both taxable and tax-deferred portfolios we replace the Core portfolio’s current Emerging Market stock exposure and Developed Market stock exposure with a broad ESG Emerging Market ETF (ESGE) and a broad ESG Developed Market ETF (ESGD), respectively. Because of limited liquidity among other Emerging Market and Developed Market SRI funds, non-SRI market-capitalization based ETFs, which are not screened for ESG criteria, are used as alternative tickers for TLH+.
Third, in tax-deferred portfolios we replace the Core portfolio’s current US High Quality Bond exposure with an ESG US High Quality Bond fund (EAGG).
A more subtle difference is that ESG funds tend to tilt away from small-cap stocks when compared to the broader market, as small-cap stocks often score poorly from an ESG perspective. As a result, the SRI portfolio may have limited investments in small cap stocks. Additionally, the Core portfolio has a tilt towards small cap and value, which is removed from all of the SRI portfolios in favor of using more funds screened for socially responsible criteria.
ESGU, DSI, SUSA, ESGD, ESGE, and EAGG each track a benchmark index that screens out companies involved in specific activities and selectively includes companies that score relatively highly across a broad set of ESG metrics. ESGU, ESGD, ESGE, and EAGG exclude tobacco companies, thermal coal companies, oil sands companies, certain weapons companies (such as those producing landmines and bioweapons), and companies undergoing severe business controversies. The benchmark index for DSI explicitly filters out companies involved in tobacco, military weapons, civilian firearms, GMOs, nuclear power, alcohol, and adult entertainment. SUSA benchmark index screens out tobacco companies and companies that have run into recent ESG controversies (a few examples were mentioned earlier).
Some of our allocations to bonds continue to be expressed using non-SRI focused ETFs since either the corresponding SRI alternatives do not exist or may lack sufficient liquidity. These non-SRI funds continue to be part of the portfolios for diversification purposes.
An example of how a Betterment Broad Impact portfolio for IRA accounts at a 70% stock allocation, with its primary tickers, is shown in Figure 4. Taxable portfolios are similar but with the replacement of US High Quality SRI Bond exposure (EAGG primary) by US Municipal bonds (MUB primary) as is implemented currently for Betterment Core portfolios.
Figure 4. Betterment Broad Impact Portfolio for IRA – 70% Stock Allocation
Based on the primary ticker holdings, the following are the main differences between Betterment’s Broad Impact portfolio and Core portfolio:
- Replacement of market cap-based US stock exposure and value style US stock exposure in the Core portfolio, with SRI-focused US stock market fund, ESGU, in the Broad Impact portfolio.
- Replacement of market cap-based developed market stock fund exposure in the Core portfolio, with SRI-focused emerging market stock fund, ESGD, in the Broad Impact portfolio.
- Replacement of market cap-based emerging market stock fund exposure in the Core portfolio, with SRI-focused emerging market stock fund, ESGE, in the Broad Impact portfolio.
- Replacement of market-weighted US high quality bond fund exposure in the Core portfolio, with SRI-focused US high quality bond fund, EAGG, in the Broad Impact portfolio.
SRI portfolios can also support our core products for increasing after-tax returns, Tax-loss Harvesting+ (TLH) and Tax-coordinated portfolios (TCP). In the Broad Impact portfolio, because of limited fund availability in the developed and emerging market SRI spaces, we use non-SRI market cap-based funds, like VWO, SPEM, VEA, and IEFA as secondary and tertiary funds for ESGE and ESGD when TLH is enabled.
How does the legacy SRI portfolio compare to the current SRI portfolios?
There are certain differences between the legacy SRI portfolio and the current SRI portfolios. If you invested in the legacy SRI portfolio prior to October 2020 and chose not to update to one of the SRI portfolios, your legacy SRI portfolio does not include the above described enhancements to the Broad Impact portfolio. The legacy SRI portfolio may have different portfolio weights, meaning as we introduce new asset classes and adjust the percentage any one particular asset class contributes to a current SRI portfolio, the percentage an asset class contributes to the legacy SRI portfolio will deviate from the makeup of the current SRI portfolios and Betterment Core portfolio. The legacy SRI portfolio may also have different funds, ETFs, as compared to both the current versions of the SRI portfolios and the Betterment Core portfolio. Lastly, the legacy SRI portfolio may also have higher exposure to broad market ETFs that do not currently use social responsibility screens and retain exposure to companies and industries based on previous socially responsible benchmark measures that have since been changed. The legacy SRI portfolio will not be monitored for future updates and any future updates will not be reflected in the legacy SRI portfolio.
As mentioned earlier, we use the ESG data and analytics from MSCI to quantify how SRI-oriented our portfolios are. For each company that they cover, MSCI calculates a large number of ESG metrics across multiple environmental (E), social (S), and governance (G) pillars and themes (recall Table 1 above). All these metrics are first aggregated at the company level to calculate individual company scores. At the fund level, an overall MSCI ESG Quality score is calculated based on an aggregation of the relevant company scores. As defined by MSCI, this fund level ESG Quality score reflects “the ability of the underlying holdings to manage key medium- to long‐term risks and opportunities arising from environmental, social, and governance factors”. These fund scores can be better understood given the MSCI ESG Quality Score scale shown below. See MSCI’s ESG Fund Ratings for more detail.
Table 2. The MSCI ESG Quality Score Scale
|The ESG Quality Score measures the ability of underlying holdings to manage key medium- to long-term risks and opportunities arising from environmental, social, and governance factors.|
|8-10||Very high ESG quality — underlying holdings largely rank best in class globally based on their exposure to and management of key ESG risks and opportunities|
|6-8||High ESG quality — underlying holdings largely rank above average globally based on their exposure to and management of key ESG risks and opportunities|
|4-6||Average ESG quality — underlying holdings rank near the global peer average, or ESG quality of underlying holdings is mixed|
|2-4||Low ESG quality< — underlying holdings largely rank below average globally based on their exposure to and management of key risks and opportunities|
|0-2||Very low ESG quality — underlying holdings largely rank worst in class globally based on their exposure to and management of key ESG risks and opportunities|
Based on data from MSCI, which the organization has made publicly available for funds to drive greater ESG transparency, and sourced by fund courtesy of etf.com, Betterment’s 100% stock Broad Impact portfolio has a weighted MSCI ESG Quality score that is approximately 28% greater than Betterment’s 100% stock Core portfolio.
The data shown in Table 3 and the scale presented in Table 2 show that, on average, while current Betterment Core portfolios hold US, Developed and Emerging Market stocks that are of Average to High ESG quality, Broad Impact portfolios invest in US, Developed and Emerging Market stocks that are of High to Very High ESG quality.
MSCI ESG Quality Scores
Betterment Core Portfolio: 5.94
Betterment Broad Impact Portfolio: 7.31
Emerging Markets Stocks
Betterment Core Portfolio: 4.22
Betterment Broad Impact Portfolio: 6.31
Developed Markets Stocks
Betterment Core Portfolio: 6.81
Betterment Broad Impact Portfolio: 8.33
US High Quality Bonds
Betterment Core Portfolio: 6.13
Betterment Broad Impact Portfolio: 6.91
Table 3. Sources: MSCI ESG Quality Scores courtesy of etf.com, values accurate as of August 25, 2020 and are subject to change. In order to present the most broadly applicable comparison, scores are with respect to each portfolio’s primary tickers exposure, and exclude any secondary or tertiary tickers that may be purchased in connection with tax loss harvesting.
A Note on ESG Risks and Opportunities
An ESG risk captures the negative externalities that a company in a given industry generates that may become unanticipated costs for that company in the medium- to long-term. An example of such a risk is the possible need to reformulate a company’s product due to a regulatory ban on a key chemical input. An ESG opportunity for a given industry is considered to be material if companies will capitalize over a medium- to long-term time horizon. Examples of ESG opportunities include the use of clean technology for the LED lighting industry. See MSCI ESG Ratings Methodology (April 2020) for more detail.
For a company to score well on a key ESG issue (see Table 1 above), both the exposure to and management of ESG risks are taken into account. The extent to which an ESG risk exposure is managed needs to be commensurate with the level of the exposure. If a company has high exposure to an ESG risk, it must also have strong ESG risk management in order to score well on the relevant ESG key issue. A company that has limited exposure to the same ESG risk, only needs to have moderate risk management practices in order to score as highly. The converse is true as well. If a company that is highly exposed to an ESG risk also has poor risk management, it will score more poorly in terms of ESG quality than a company with the same risk management practices, but lower risk exposure.
For example, water stress is a key ESG issue. Electric utility companies are highly dependent on water with each company more or less exposed depending on the location of its plants. Plants located in the desert are highly exposed to water stress risk while those located in areas with more plentiful water supplies present lower risk. If a company is operating in a location where water is scarce, it needs to take much more extensive measures to manage this risk than a company that has access to abundant water supply.
V. Should we expect any difference in an SRI portfolio’s performance?
One might expect that a socially responsible portfolio could lead to lower returns in the long term compared to another, similar portfolio. The notion behind this reasoning is that somehow there is a premium to be paid for investing based on your social ideals and values.
A white paper by the Morgan Stanley Institute for Sustainable Investing, however, shows that this claim is questionable at best. This paper summarized the results from a study that analyzes the performance of nearly 11,000 funds from 2004 to 2018 and compares traditional funds to sustainable funds. The primary takeaway of the study revealed that there was no trade-off in performance when comparing sustainable to traditional funds. The study suggests they were only able to find sporadic and inconsistent differences in returns, which suggests that while there can be differences in performance over shorter time periods, over the long term there is likely no meaningful difference. The second significant finding from the study was that sustainable funds exhibited 20% lower downside risk, as measured by downside deviation.
When considering the possible performance of Betterment’s SRI portfolios (excluding the legacy SRI portfolio), we examined evidence based on both historical and forward-looking analyses described below. When adjusting for the stock allocation level, the data indicates that the performance of Betterment’s Broad Impact portfolio versus our Core portfolio is not significantly different.
Backtests Based on Historical Returns
Past performance does not guarantee future results. Nonetheless, our analysis of historical returns is consistent with our assertion that the performance of SRI portfolios should track the performance of the Core portfolios very closely. An analysis of the historical total gross returns over the past four years shows that SRI portfolios and Core portfolios have been very highly correlated. In Figure 5 we illustrate this high correlation using Broad Impact IRA portfolios at a 70% stock allocation as an example. Both Taxable and IRA portfolios exhibit similar properties given other stock allocation levels.
Figure 5. Betterment Core Portfolio vs Broad Impact Portfolio Monthly Returns
Figure 5. Based on historical returns of a 70% stock allocation portfolio gross of all fees for the four year period ending August 31, 2020.*
But how do the net returns compare? In Figure 6 we show that the weighted expense ratios of the Broad Impact portfolio is higher than those of Core portfolios at non-zero stock allocation levels (and the spread increases as you add more stocks to the mix). You might expect that the higher expense ratios would drag down the net performance of Broad Impact portfolios relative to Core portfolios.
Figure 6. Weighted Expense Ratios For All IRA Portfolio Allocations
Figure 6. Sources: Xignite. Calculations by Betterment as of October 14, 2020. Weighted expense ratios for each portfolio are calculated using the expense ratios of the primary ETFs used for IRA allocations of Betterment’s portfolios as of October 2020.
As it turns out, after reducing returns both by weighted expense ratios and a 0.25% annual Betterment fee, the performance of the Broad Impact portfolio ended up being similar to that of Core portfolio for the consecutive four year period ending on August 31, 2020, with the Broad Impact portfolio outperforming over this specific period. Table 3 provides an example of this claim for IRA portfolios at a 70% stock allocation. Performance summaries for other stock allocation levels as well as for taxable portfolios look similar.
Table 4. Comparing Net Performance
70% Stock Allocation Portfolios for Four Year Period ending August 31, 2020
|Betterment Portfolio||Betterment Broad Impact|
|Annualized Return (net)||7.76%||9.18%|
|Annualized Standard Deviation||11.19%||10.46%|
*Performance information for Table 4 ‘Comparing Net Performance’ and for Figure 5 ‘Betterment Core Portfolio vs Broad Impact Portfolio Monthly Returns’ for the Betterment allocations are based on a backtest of the ETFs or indices tracked by each asset class in Betterment’s portfolios as of October 2020. Though we have made an effort to closely match performance results shown to that of the Betterment Portfolio over time, these results are entirely the product of a model. Actual client experience could have varied materially. Performance figures assume dividends are reinvested and daily portfolio rebalancing at market closing prices. The returns are net of a 0.25% annual management fee and fund level expenses. Backtested performance does not represent actual performance and should not be interpreted as an indication of such performance. Actual performance for client accounts may be materially lower. Backtested performance results have certain inherent limitations. Such results do not represent the impact that material economic and market factors might have on an investment adviser’s decision-making process if the adviser were actually managing client money. Backtested performance also differs from actual performance because it is achieved through the retroactive application of model portfolios designed with the benefit of hindsight. As a result, the models theoretically may be changed from time to time and the effect on performance results could be either favorable or unfavorable. See additional disclosure https://www.betterment.com/returns-calculation/. Source: Price data from Xignite. Calculations by Betterment.
In Figure 7, we graph expected net total returns at each risk (stock allocation) level for both Betterment Core and Broad Impact portfolios. All expected total returns are expressed in annual terms and are net of the portfolio weighted ETF annual expense ratios and a 0.25% annual Betterment fee. Based on the application of Black-Litterman and mean-variance portfolio optimization methods, they are our best estimates of the actual returns, net of known fees, that you might expect to achieve on average annually. The expected net total returns of Betterment’s Broad Impact portfolio are only slightly below those of the Betterment Core portfolio. The higher weighted expense ratios of Broad Impact portfolios account for a large component of their expected underperformance.
Figure 7. Comparison of Broad Impact and Core IRA Efficient Frontiers
Assumes a risk-free rate of 1.47%
Sources: Market capitalization data collected from S&P Dow Jones Indices, SIFMA, and Bank for International Settlements. Price data are from Xignite. A risk-free rate assumption of 1.47% is for a 10-year horizon and is derived using our methods for estimating the forward curve as of October 14, 2020. The forward looking returns are shown net of known fund fees and Betterment’s 0.25% management fee. Calculations by Betterment.
Dividend Yields Could Be Lower
Dividend yields calculated over the past year (ending August 25, 2020) indicate that income returns coming from Broad Impact portfolios have been lower than those of Core portfolios recently (see Figure 8). Oil and gas companies like BP, Chevron, and Exxon, for example, currently have relatively high dividend yields and excluding them from a given portfolio can cause its income return to be lower. Of course, future dividend yields are random variables and past data may not provide accurate forecasts. Nevertheless, lower dividend yields can be a factor in driving total returns for SRI portfolios to be lower than those of Core portfolios.
Figure 8. Comparison of Dividend Yields
Source: Xignite, Calculations by Betterment for one year period ending October 14, 2020. Dividend yields for each portfolio are calculated using the dividend yields of the primary ETFs used for IRA allocations of Betterment’s portfolios as of October 2020.
VI. Climate Impact Portfolio
Betterment offers a Climate Impact portfolio for investors that want to invest in an SRI strategy more focused on being climate-conscious rather than focusing on all ESG dimensions equally. The Climate Impact portfolio was designed to give investors exposure to climate-conscious investments, without sacrificing proper diversification and balanced cost. Fund selection for this portfolio follows the same guidelines established for the Broad Impact portfolio, as we seek to incorporate broad based climate-focused ETFs with sufficient liquidity relative to their size in the portfolio.
How does the Climate Impact portfolio more positively affect climate change?
Half of the stocks in the Climate Impact portfolio are allocated to iShares MSCI ACWI Low Carbon Target ETF (CRBN), an ETF which seeks to track the global stock market, but with a bias towards companies with a lower carbon footprint. By investing in CRBN, investors are actively supporting companies with a lower carbon footprint, because CRBN overweights these stocks relative to their high-carbon emitting peers. One way we can measure the carbon impact a fund has is by looking at its weighted average carbon intensity, which measures the weighted average of tons of CO2 emissions per million dollars in sales, based on the fund’s underlying holdings. Based on weighted average carbon intensity data from MSCI (courtesy of etf.com), Betterment’s 100% stock Climate Impact portfolio has carbon emissions per unit sales more than 50% lower than Betterment’s 100% stock Core portfolio as of September 15, 2020.
The remaining half of the stocks in the Climate Impact portfolio are allocated to fossil fuel reserve free funds, SPYX, EFAX, and EEMX. Rather than ranking and weighting funds based on a certain climate metric like CRBN, these funds instead exclude companies that own fossil fuel reserves, defined as crude oil, natural gas, and thermal coal. By investing in fossil fuel reserve free funds investors are actively divesting from companies with some of the most negative impact on climate change, including oil producers, refineries, and coal miners such as Chevron, ExxonMobile, BP, and Peabody Energy.
Another way that the Climate Impact portfolio promotes a positive environmental impact is by investing in bonds that fund green projects. The Climate Impact portfolio invests in iShares Global Green Bond ETF (BGRN), which tracks the global market of investment-grade bonds linked to environmentally beneficial projects, as determined by MSCI. These bonds are called “green bonds”. The green bonds held by BGRN fund projects in a number of environmental categories defined by MSCI including alternative energy, energy efficiency, pollution prevention and control, sustainable water, green building, and climate adaptation.
How does the Climate Impact portfolio compare to Betterment’s Core portfolio?
When compared to the Betterment Core portfolio allocation, there are three main changes. First, in both taxable and tax-deferred portfolios, replace 50% of our Core portfolio’s Total Stock exposure with an allocation to a broad global low-carbon stock ETF (CRBN) in the Climate Impact portfolio. Currently, there are not any viable alternative tickers for the global low-carbon stock asset class so this component of the portfolio cannot be tax-loss harvested.
Second, we allocate the remaining 50% of our Core portfolio’s Total Stock exposure to three broad region-specific stock ETFs that screen out companies that hold fossil-fuel reserves in the Climate Impact portfolio. US Total Stock Market exposure is replaced with an allocation to SPYX, International Developed Stock Market exposure is replaced by EFAX, and Emerging Markets Stock Market exposure is replaced by EEMX. In the Climate Impact portfolio, SPYX, EFAX, and EEMX will use ESG secondary tickers ESGU, ESGD, and ESGE respectively for tax loss harvesting.
Lastly, for both taxable and tax-deferred portfolios we replace both our Core portfolio’s US High Quality Bond and International Developed Market Bond exposure with an allocation to a global green bond ETF (BGRN) in the Climate Impact portfolio.
Some of our allocations to bonds continue to be expressed using non-climate focused ETFs since either the corresponding alternatives do not exist or may lack sufficient liquidity. These non-climate-conscious funds continue to be part of the portfolios for diversification purposes.
How do performance expectations compare to the Core portfolio?
When some first consider ESG investing, they assume that they must pay a heavy premium in order to have their investments aligned with their values. However, as previously noted in Section V, the data suggests that the performance between sustainable funds versus traditional funds is not significantly different, although there can be differences over shorter periods. We also compared Betterment’s Broad Impact portfolio’s returns versus our Core portfolio’s and show the two are highly correlated. This holds true for the Climate Impact portfolio as well. BGRN, the global green bond ETF, was created in November of 2018, so backtests on historical returns are limited. However, we can still examine the Climate Impact portfolio’s return versus Betterment’s Core portfolio to get an idea as to whether they’ve been similar since BGRN’s inception. In Figure 9, comparing an IRA portfolio with a 70% stock allocation, we show that the returns of the portfolios are certainly directionally aligned, while the Climate Impact portfolio actually outperformed (+22.3% vs +15.9%) over the shorter time horizon.
Betterment Core 70% Stock Returns vs. Betterment Climate Impact 70% Stock Returns
Figure 9. This plot shows the cumulative return of the IRA 70% stock allocation for both the Betterment Core portfolio as well as the Climate Impact portfolio from November 28, 2018 to September 16, 2020. Performance information for the Betterment allocations is based on the time-weighted returns of Betterment IRA portfolios with primary tickers that are at the target allocation every market day (this assumes portfolios are rebalanced daily at market closing prices). Dividends are assumed to be reinvested in the fund from which the dividend was distributed. Betterment allocations reflect portfolio holdings as of September 2020 and include an annual 0.25% management fee. This does not include deposits or withdrawals over the performance period. These allocations are not representative of the performance of any actual Betterment account and actual client experience may vary because of factors including, individual deposits and withdrawals, secondary tickers associated with tax loss harvesting, allowed portfolio drift, transactions that do not occur at close of day prices, and differences in holdings between IRA and taxable portfolios. Investing in securities involves risks, and there is always the potential of losing money when you invest in securities. Market conditions can and will impact performance. Past performance is not indicative of future results. Source: Returns data from Xignite. Calculations by Betterment.
Now that we have examined how the Climate Impact portfolio has performed historically since inception, we next focus on forward-looking analysis. In Figure 10, we show that the weighted expense ratios of Climate Impact portfolios are higher than those of Core portfolios at non-zero stock allocation levels (and the spread increases as you add more stocks to the mix). However in Figure 11, when we examine this difference within the context of our best estimates of future returns, net of known fees, the expected net total returns of Climate Impact portfolios are only slightly below those of Betterment Core portfolios. The higher weighted expense ratios of Climate Impact portfolios primarily account for their future expected underperformance.
Figure 10. Weighted Expense Ratios for IRA Portfolio Allocations
Figure 10. Sources: Xignite. Calculations by Betterment as of October 14, 2020. Weighted expense ratios for each portfolio are calculated using the expense ratios of the primary ETFs used for IRA allocations of Betterment’s portfolios as of October 2020.
Figure 11. Comparison of Climate Impact SRI and Core IRA Efficient Frontiers
Figure 11. Sources: Market capitalization data collected from S&P Dow Jones Indices, SIFMA, and Bank for International Settlements. Price data are from Xignite. A risk-free rate assumption of 1.47% is for a 10-year horizon and is derived using our methods for estimating the forward curve as of October 14, 2020. The forward looking returns are shown net of known fund fees and Betterment’s 0.25% management fee. Calculations by Betterment.
Betterment offers a Social Impact portfolio for investors that want to invest in a strategy more focused on the social pillar of ESG investing (the S in ESG). The Social Impact portfolio was designed to give investors exposure to investments which promote social equity, without sacrificing proper diversification and balanced cost. Fund selection for this portfolio follows the same guidelines established for the Broad Impact portfolio discussed above, as we seek to incorporate broad based ETFs that focus on social equity with sufficient liquidity relative to their size in the portfolio.
How does the Social Impact portfolio promote social equity?
The Social Impact portfolio shares many of the same holdings as Betterment’s SRI portfolio, which means the portfolio holds funds which rank strongly with respect to broad ESG factors. The Social Impact portfolio looks to further promote the social pillar of ESG investing, by also allocating to two ETFs that specifically focus on diversity and inclusion — Impact Shares NAACP Minority Empowerment ETF (NACP) and SPDR SSGA Gender Diversity Index ETF (SHE).
NACP is a US stock ETF offered by Impact Shares that tracks the Morningstar Minority Empowerment Index. The National Association for the Advancement of Colored People (NAACP) has developed a methodology for scoring companies based on a number of minority empowerment criteria. These scores are used to create the Morningstar Minority Empowerment Index, an index which seeks to maximize the minority empowerment score while maintaining market-like risk and strong diversification. The end result is an index which provides greater exposure to US companies with strong diversity policies that empower employees irrespective of race or nationality. By investing in NACP, investors are allocating more of their money to companies with a better track record of social equity as defined by the NAACP.
SHE is a US Stock ETF that allows investors to invest in more female-led companies compared to the broader market. In order to achieve this objective, companies are ranked within each sector according to their ratio of women in senior leadership positions. Only companies that rank highly within each sector are eligible for inclusion in the fund. By investing in SHE, investors are allocating more of their money to companies that have demonstrated greater gender diversity within senior leadership than other firms in their sector.
For more information about these social impact ETFs, including any associated risks, please see our disclosures.
How does the Social Impact portfolio compare to Betterment’s Core portfolio?
The Social Impact portfolio builds off of the ESG exposure from funds used in the Broad Impact portfolio and makes the following additional changes.
First, we replace 10% of our US Total Stock Market exposure with an allocation to a US Stock ETF, NACP, which provides exposure to US companies with strong racial and ethnic diversity policies in place.
Second, we replace an additional 10% of our US Total Stock Market exposure with an allocation to a US Stock ETF, SHE, which provides exposure to companies with a relatively high proportion of women in high-level positions.
Currently, there are not any viable alternative tickers for NACP or SHE, so these components of the portfolio will not be tax-loss harvested.
How do performance expectations compare to the Core portfolio?
When some first consider ESG investing, they assume that they must pay a heavy premium in order to have their investments aligned with their values. However, as previously noted in Section V, the data suggests that the performance between sustainable funds versus traditional funds is not significantly different, although there can be differences over shorter periods. We also compared Betterment’s Broad Impact portfolio’s returns to our Core portfolio’s and show the two are highly correlated. This holds true for the Social Impact portfolio as well. NACP, the minority empowerment ETF, was created in July of 2018, so backtests on historical returns are limited. However, we can still examine the Social Impact portfolio’s return versus the Betterment Core portfolio’s return to get an idea as to whether they’ve been similar since NACP’s inception. In Figure 12, comparing an IRA portfolio with a 70% stock allocation, we show that the portfolios are directionally aligned, while the Social Impact portfolio actually outperformed (+25.4% vs +19.6%) over the shorter time period.
Figure 12. Betterment Core 70% Stock Returns vs. Betterment Social Impact 70% Stock Returns
Figure 12. This plot shows the cumulative return of the IRA 70% stock allocation for both the Betterment Core portfolio as well as the Social Impact portfolio from October 25, 2018 to September 16, 2020. Performance information for the Betterment allocations is based on the time-weighted returns of Betterment IRA portfolios with primary tickers that are at the target allocation every market day (this assumes portfolios are rebalanced daily at market closing prices). Dividends are assumed to be reinvested in the fund from which the dividend was distributed. Betterment allocations reflect portfolio holdings as of September 2020 and include an annual 0.25% management fee. This does not include deposits or withdrawals over the performance period. These allocations are not representative of the performance of any actual Betterment account and actual client experience may vary because of factors including, individual deposits and withdrawals, secondary tickers associated with tax loss harvesting, allowed portfolio drift, transactions that do not occur at close of day prices, and differences in holdings between IRA and taxable portfolios. Investing in securities involves risks, and there is always the potential of losing money when you invest in securities. Market conditions can and will impact performance. Past performance is not indicative of future results. Source: Returns data from Xignite. Calculations by Betterment.
Now that we have examined how the portfolio has performed historically since inception, we next focus on forward-looking analysis. In Figure 13 we show that the weighted expense ratios of Social Impact portfolios are higher than those of core portfolios at non-zero stock allocation levels (and the spread increases as you add more stocks to the mix). However in Figure 14, when we examine this difference within the context of our best estimates of future returns, net of known fees, the expected net total returns of Social Impact portfolios are only slightly below those of Betterment core portfolios. The higher weighted expense ratios of Social Impact portfolios primarily account for their future expected underperformance.
Figure 13. Weighted Expense Ratios for IRA Portfolio Allocations
Figure 13. Sources: Xignite. Calculations by Betterment as of October 14, 2020. Weighted expense ratios for each portfolio are calculated using the expense ratios of the primary ETFs used for IRA allocations of Betterment’s portfolios as of October 2020.
Figure 14. Comparison of Social Impact SRI and Core IRA Efficient Frontier
Figure 14. Sources: Market capitalization data collected from S&P Dow Jones Indices, SIFMA, and Bank for International Settlements. Price data are from Xignite. A risk-free rate assumption of 1.47% is for a 10-year horizon and is derived using our methods for estimating the forward curve as of October 14, 2020. The forward looking returns are shown net of known fund fees and Betterment’s 0.25% management fee. Calculations by Betterment.
SRI portfolios are designed to help you express your values and social ideals through your investments. Despite the various limitations that all SRI implementations face today, Betterment will continue to support its customers in further aligning their values to their investments. Betterment may add additional socially responsible funds to the SRI portfolios and replace other ETFs as more socially responsible products become available. We are now able to provide you with multiple globally diversified SRI portfolios, at relatively low cost that are expected to track the performance of the long-standing Betterment Core portfolio closely.
We released our first SRI offering in 2017, with the stated intent to incrementally improve it over time, and we’ve done just that. You can think of these iterations as the latest, and certainly not the last step in that journey. By indicating what matters to you, as an investor, you are sending a signal to the financial services industry, which we will amplify, by bundling it with those of our other customers. As demand grows, and assets flow into funds that best reflect your values, those funds will become bigger, cheaper, and more liquid, continuing to erase whatever accessibility gaps remain between purely market-cap based index funds, and those that track a values-based index. As a result, the SRI portfolio you opt for today will only keep getting better at expressing your values.