Socially Responsible Investing with Wealthfront

Introduction

Wealthfront offers two types of fully managed, diversified, automated portfolios to clients: Classic portfolios and Socially Responsible portfolios. This white paper discusses the construction of Wealthfront’s Socially Responsible portfolios, which are designed to offer similar risk-adjusted returns as our Classic portfolios with a focus on socially responsible investing.

What is Socially Responsible Investing?

While socially responsible investing (SRI) doesn’t have a single agreed-upon definition, it’s generally seen as an investment strategy that evaluates companies based on their benefit and/or detriment to society, rather than profits or intrinsic value alone. This concept comes from an ethical framework called “social responsibility,” in which individuals and corporations have an obligation to cooperate with others to benefit greater society. Some investors may take up SRI strategies due to a long-term belief in its investment value, and others may decide to use this strategy purely due to ethics.

Since there’s no agreed-upon definition of SRI, investors evaluate which investments to include in an SRI strategy in a variety of ways. Some investors may take an exclusionary approach, avoiding stocks or bonds if the underlying company is involved in activities considered detrimental to society. For example, a fund manager building an SRI ETF (exchange-traded fund) might exclude stocks involved in fossil fuel extraction, firearms, or tobacco from their portfolio. At the other end of the spectrum, some investors may only invest in companies if their business activities agree with a particular set of values considered beneficial to society, an approach known as “impact investing.” Examples of impact investments include clean energy portfolios and a portfolio of companies committed to promoting diverse leadership. Investors may also combine elements of both strategies, excluding companies from certain industries and investing a relatively high fraction of the portfolio in companies whose businesses align with their values.

For Wealthfront’s Socially Responsible Investing portfolios, SRI means promoting social impact by selecting investments that increase exposure to companies receiving high scores on ESG factors. 

What is ESG?

You may have heard the term “ESG” in relation to SRI. ESG stands for environmental, social, and governance — three pillars of corporate social responsibility. Each pillar contains specific factors on which companies can be measured.

Environmental factors take into account a company’s conservation efforts, scored on areas such as:

• Climate change
• Carbon emissions
• Air and water pollution
• Biodiversity
• Deforestation
• Energy efficiency
• Waste management
• Water usage intensity

Social factors take into account a company’s practices regarding people and relationships, such as its consideration of human rights, labor laws, and customer relationships. These measures are scored on areas such as:

• Diversity
• Human rights and labor standards
• Customer satisfaction
• Data privacy and protection
• Customer and employee relations
• Community relations

Governance factors take into account a company’s standards for management, scored on areas such as:

• Board composition
• Audit committee structure
• Executive compensation
• Lobbying and political contributions
• Whistleblower schemes, bribery and corruption

ESG Scoring

We use ESG-aware Blackrock funds as the primary funds in our Socially Responsible portfolios. These funds track socially responsible indices defined by MSCI, which also scores the underlying stocks or bonds on ESG factors.

Each company in the MSCI index is scored on a weighted collection of factors within the three ESG pillars, with criteria that vary by how important each factor is deemed to that company’s industry. For example, within the environmental pillar, companies in the soft drinks industry are scored on three factors — water stress, packaging material and waste, and carbon footprint, while companies within the healthcare services industry are scored only on carbon emissions.

Index Creation

With the ESG quality scores of the individual companies assigned, MSCI next determines the weight of each instrument in the relevant index. Companies in certain industries or that derive meaningful fractions of their revenue from activities deemed controversial by MSCI are excluded entirely. These industries include civilian firearms, controversial weapons, tobacco, thermal coal and oil sands, and the details can be found here. To determine the weights on the individual stocks or bonds, MSCI uses an optimization process designed to maximize the weighted-average ESG quality score of the portfolio, subject to constraints intended to keep the risk and return profile of the ESG index similar to that of a standard (non-ESG) index called the “parent index”, and to control trading from rapid weight changes. These constraints include:

• An upper bound on the expected tracking error between the ESG index and the parent.
• Maximum weights of individual companies relative to their weight in the parent.
• Maximum weights of sectors and countries relative to the parent.
• Upper bounds on total turnover. Turnover is defined as the sum of the magnitude of weight changes from the last definition to the current one.

Each fund in Blackrock’s suite of ESG-aware ETFs seeks to track the performance of a particular MSCI index. The overall ESG quality score of an ETF is simply the weighted average of the scores of its holdings on a range from 0 to 10, with 10 being the best. Note that while nearly all companies and funds are assigned scores by MSCI, there are certain companies and instruments that haven’t been scored. For example, Municipal bonds do not receive ESG ratings.

Choosing Asset Classes and Instruments

To balance returns and impact, we generally choose ETFs that track indices favoring companies with higher overall ESG quality scores while maintaining low tracking error to the “standard” indices.

Each of the ETFs in our Socially Responsible portfolios represents a specific asset class, in line with our implementation of Modern Portfolio Theory (which is described at length in our Investment Methodology white paper). Table 1 shows the asset classes represented in each set of portfolios, as well as the ETFs selected to represent each asset class.

While we do our best to find socially responsible ETFs for every part of your portfolio, not all asset classes have adequate socially responsible ETFs that can be used to represent them. In some cases, we choose to remove the unrepresented asset class entirely, such as with Dividend Stocks, Emerging Bonds, and Real Estate. In other cases, like with Municipal Bonds and Treasury Inflation-Protected Securities (TIPS), we use the same ETF employed by our Classic portfolios. Although these ETFs are not explicitly designed to adhere to SRI principals, bonds issued by the US government and municipalities fund beneficial spending such as infrastructure, schools, and social programs. Moreover, TIPS and municipal bonds aid in diversification and tax-efficiency.

In addition to the overall ESG quality score, we highlight a second sustainability metric, which scores companies based on their carbon emissions. This metric, called carbon intensity, is calculated by MSCI and captures the tons of carbon dioxide emitted by each company, per million dollars in sales. We don’t use this metric when selecting ETFs or in portfolio construction, but we find that it is an informative and tangible measure that the SRI portfolios tend to improve upon. As with the ESG quality score, the carbon intensity score for an ETF is the weighted-average score of its holdings. Table 2 compares the ESG quality scores and carbon intensity scores between ETFs used in our Classic portfolios and Socially Responsible portfolios for the asset classes with socially responsible variants. Note that a more socially responsible fund will have a higher ESG quality score and a lower carbon intensity score. 

The ETFs used in our Socially Responsible portfolios score significantly better than those used in our Classic portfolios on both ESG quality and carbon intensity, with the exception of the corporate bonds category. The ETF used to represent this asset class in the Socially Responsible portfolios (SUSC) has a slightly higher carbon intensity score than the ETF used in the Classic portfolios (LQD). This is because the index that SUSC tracks is designed to increase the weighted average of the overall ESG quality score, and environmental factors are only one part of the overall score.

Table 3 shows the realized performance of the ETF representing each of these asset classes in both the Classic and Socially Responsible portfolios. The annualized return and volatility values are measured using daily data starting from the inception date of the ETF used in the Socially Responsible portfolios and ending on August 31, 2021. There is no clear pattern in the performance of the SRI ETFs compared to the standard funds. In some cases, the SRI ETF has had better performance or lower volatility, while in other cases the opposites are true. Although the comparison periods of three to five years are fairly short, the lack of any pattern in the performance numbers reinforces our expectation that the performance of the SRI ETFs should be similar to that of the standard funds — and that the performance of portfolios composed of SRI ETFs should be similar to the performance of portfolios constructed using the standard funds. Note that the realized returns include fees, which are also shown in the table. The fees of socially responsible ETFs we have chosen are between 0.04% and 0.15% higher than their non-SRI counterparts — still well below the average expense ratio of 0.66% for actively managed mutual funds, as reported by Morningstar.

Constructing Portfolios

Once we have decided on the asset classes and instruments to employ in the Socially Responsible portfolio, we choose weights for each instrument in the overarching portfolio. To do this, we use the same process described in our general investment methodology white paper.

Our portfolio construction process assumes that there is no difference, before taxes and fees, in expected return between each SRI ETF and its non-SRI counterpart. However, we do account for differences in dividend yields and expense ratios, which affect net-of-fee, after-tax returns, in our assumptions. Table 4 shows our assumptions for these returns values.

After calculating expected returns after taxes and fees, we use the same portfolio optimization process described in our investment methodology white paper to determine the weights of each portfolio. The final weights of each Socially Responsible portfolio are shown in Figures 1 and 2, for taxable and IRA accounts, respectively. Asset classes represented by socially responsible ETFs are shown in bold type.

The substitution of socially responsible ETFs into these portfolios improves their sustainability characteristics substantially. To get a portfolio-level score for the ESG quality and carbon intensity metrics mentioned previously, we take a weighted average, excluding municipal bonds (municipal bonds do not receive ESG scores). In taxable portfolios, the weighted-average ESG score increases from an average of 5.9 to an average of 7.2. Figure 3 shows the values for each risk score. In IRA accounts, the improvement is similar — the weighted-average score increases from 5.8 to 7.4.

Figure 4 shows the weighted-average carbon intensity for taxable portfolios of each type and risk score. As with the ESG score, the Socially Responsible portfolios see a sizable improvement in this metric, from an average of 154.8 to 104.9 — an average decrease of over 30%. For IRA portfolios, the improvement is even larger, with carbon intensity decreasing by over 50% on average.

In the risk score 8 portfolio (one of our most commonly-chosen taxable portfolios), the carbon intensity score drops from 172.6 to 113.1. This translates to a decrease of 58 tons of carbon dioxide equivalents for every million dollars invested in the SRI portfolio rather than the Classic portfolio. This is approximately equal to the emissions from thirteen passenger cars or the heating of seven homes for an entire year.

Rebalancing and Ongoing Management

Our SRI portfolios are managed using the same process as our Classic portfolios, including tax-loss harvesting, dividend reinvestment, and tax-efficient rebalancing and withdrawals.

Every ETF used in our SRI portfolios is eligible for tax-loss harvesting, meaning that Wealthfront clients choosing our SRI option in a taxable account still get the full benefit of our tax-loss harvesting service. Table 6 shows the primary and secondary ETFs used for each of the five asset classes where socially responsible funds are available. Each alternate ETF is highly correlated with the primary ETF used to represent the asset class.

Conclusion

According to a robust scoring framework, Wealthfront’s Socially Responsible portfolios show significant improvement in social good and sustainability metrics when compared to our Classic portfolios. At the same time, the Socially Responsible portfolio benefits from the same investment expertise and state-of-the-art asset allocation techniques as our Classic portfolios.

Disclosures