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A mid continued global upheaval, 2021 has been a strong year so far for environmental, social and governance (ESG) ETFs, with 10 of the 22 ETFs launched in July focusing on ESG.

This type of growth is spurring interest among clients, along with concerns of greenwashing within the fund industry — funds of dubious environmental standing calling themselves “green.”

Two professionals familiar with ESG ETFs shared their insights.

Disciplined ESG integration

George Ripoll, an investment advisor in Peterborough, Ont. with BMO Nesbitt Burns Inc., said ESG integration is a key part of his portfolio-building process. So is impact investing, which not only helps local and global communities, but also boosts the long-term value of his clients’ portfolios.

Ripoll focuses on stock selection, most often using ETFs for risk mitigation and efficient bond exposure, but he also has clients with ETF-only portfolios.

When choosing any investment, Ripoll begins by simply zeroing in on companies that generate “strong, organic operating free cash flow,” he said, noting that his main focus is on mid- to large-cap names in North America. He also seeks names that “are adapting rapidly to the changing environment. That’s not just from an environmental standpoint, but also considering future policy and regulations,” Ripoll said. Changing ESG disclosure and business practice rules can “completely disrupt traditional business models.”

The core holdings of Ripoll’s sample 70/30 equities/fixed-income (FI) portfolio are the iShares ESG MSCI USA Leaders Index ETF (TSE: XULR) and iShares ESG Advanced 1–5 Year Canadian Corporate Bond Index ETF (TSE: XSHG). Each of these account for 30% of the portfolio (see table) and are ETFs “we would want to hold onto through thick and thin.”

These ETFs invest in industries and companies that are forward-looking regarding issues such as board diversity and employment practices, Ripoll said. The bond ETF also offers the short duration he currently seeks.

Despite some overlap in the ETFs’ holdings, Ripoll said he still achieves diversification. The top three sectors in XULR were IT, health care and consumer discretionary, as of Aug. 23, 2021 (28.9%, 13.7% and 12.1%, respectively); the dominant exposure in the corporate bond fund was the financial sector, at 76.0%.

The IT, consumer discretionary and financial sectors feature more prominently in Ripoll’s sample portfolio than other sectors. The reasoning? Companies in these sectors generally pollute less and embrace employee diversity more than companies in other sectors, he said. Furthermore, several companies in his prominent sectors are newer and better able to quickly adapt to the fluctuating ESG environment.

The BMO MSCI Canada ESG Leaders Index ETF (TSE: ESGA) forms 20% of the portfolio and offers a domestic lens into similar themes. The ETF invests in companies with higher ESG ratings than their peers, and is most exposed to the financials, IT and industrials sectors.

The portfolio’s satellite positions — the Horizons Global Sustainability Leaders Index ETF (TSE: ETHI) and BMO Clean Energy Index ETF (TSE: ZCLN), which each form 10% of the portfolio — are regarded as thematic plays, Ripoll said.

The impact element of Ripoll’s sample portfolio largely comes from the satellite positions, which he concedes are largely passive. To bump up a portfolio’s impact, he would add individual companies that invest in a client’s community or region.

“The advisor needs to make sure they’re doing their proper due diligence,” Ripoll said. In the absence of clear ESG product guidelines, that means reviewing both ESG fund ratings and proprietary research into sustainable products that reflect an investor’s values.

Finding the sweet spot

Tim Nash, a fee-for-service, advice-only financial planner and founder of Good Investing Financial Planners Ltd. in Toronto, has been researching the ESG space for more than a decade.

Both of his sample portfolios are approximately 60/40 equities/FI mixes and part of a set of four. The two being highlighted not only exclude exposure to fossil fuels and weapons, for example, but are based on the ESG scores, revenue and products of the companies held within the ETFs.

Nash welcomes the “proliferation of ESG ETFs,” although it requires keeping tabs on fund launches. While Nash reviews MSCI’s and Morningstar’s research, he also assesses each fund’s sustainability himself.

“I have to understand whether an ESG ETF is legitimately socially responsible and how far it goes on that curve,” said Nash, who uses his research to build sample portfolios that clients deploy themselves.

If an ETF hasn’t included the most common ESG negative screens, such as weapons or tobacco, Nash avoids recommending it. Another test is an ETF’s ESG risks and scores, plus its carbon footprint — an overall measure he provides for both of his sample portfolios.

“Climate change, to me, is the most important ESG risk right now,” Nash said, “and I really put that under the microscope.”

Nash’s first sample portfolio — which offers carbon efficiency of 72.8 tons of CO2 per million dollars in sales — is tailored to passive investors who mainly want to avoid traditional “sin sectors” and who like companies that earn revenue from products related to energy efficiency and pollution control. The two ETFs in this portfolio are actively managed, he said, with the iShares ESG Balanced ETF Portfolio (TSE: GBAL) making up the lion’s share at 75%. (See table.)

“Here, I’m trying to keep it as simple as possible,” Nash said. “Many ESG investors want to push more on the ‘doing more good’ side of the equation.” But he also focuses on diversification and balancing cost.

The thematic portion of the first portfolio consists of the AGF Global Sustainable Growth Equity ETF (NEO: AGSG), at 15%, and the EcoCharge Green Bond at 10%. This bond invests in electric vehicle charging stations in Quebec and New Brunswick.

As of July 31, 2021, the AGF fund was most exposed to North America, at 50.1%, and to industrials, IT and consumer discretionary from a sector point of view (all above 10%). The ETF’s core focus included efficient energy and power technologies, and waste management.

The green bond is less liquid and riskier than the ETFs, Nash said. But the product fits well in a portfolio focused on climate impact because it’s backed by Earth Day Canada, a non-profit, and could inspire national change, Nash said.

Nash’s second sample portfolio (see table) is geared toward clients comfortable with more exclusions. For example, it avoids ETFs that include junk food-producing names and companies without women on their boards. The portfolio also offers better carbon efficiency: 25.2 tons of CO2 per million dollars in sales.

“This portfolio is for the greenest of the green,” Nash said. “[Strongly ESG-oriented clients] might look at some of the other ESG ETFs and at the companies inside and say no.”

The greener portfolio’s highest allocation (40%) is to the Horizons global leaders fund (ETHI), which Ripoll also chose. The other holdings in Nash’s greener portfolio differ, however, and its impact portion comes mainly from the Fair Finance Fund, which supports the local food chain and farmers in Ontario.

ETHI mainly captures “the low-carbon part” for this portfolio, Nash said. The CI MSCI World ESG Impact ETF (NEO: CESG.B) focuses more broadly on varied sustainable development efforts by mostly North American companies that earn significant revenue by aligning with the United Nations’ Sustainable Development Goals.

The Fair Finance Fund is especially attractive for responsible investors in Ontario who want to invest in local initiatives. Yet it only returns 2% per year compared with 3.5%–4% for the EcoCharge Green Bond in Nash’s first sample portfolio.

An alternative view

For financial advisors who prefer to choose individual stocks and are wary of issues such as greenwashing and overlap among funds, Sean Moir, portfolio manager with Mandeville Private Client Inc. in Burlington, Ont., suggested individual names.

Moir typically crafts portfolios that include 15–20 investments, with top equity names sitting at no more than 15% and satellite positions at no more than 10%. He doesn’t avoid ETFs altogether, but in-depth ESG research requires time and passion, he said — especially if you want to “move beyond the default buy-the-index and buy-and-hold approach.”

Some of the top picks Moir highlighted were Northland Power Inc. and Allied Properties REIT, both based in Toronto, as well as Calgary-based energy company Whitecap Resources Inc. Northland invests in sustainable energy developments such as wind farms, while the REIT holds heritage buildings and properties with environmental certifications. Whitecap has said it’s carbon-negative, meaning it reduces more CO2 than it produces.

One ETF that Moir likes, but hasn’t yet invested in, is the actively managed Dynamic Active Energy Evolution ETF (TSE: DXET). It invests in renewable energy transition across the globe, and one of its largest holdings is U.S.-based Generac Holdings Inc., which is turning to environmentally friendly power sources.

Moir also likes private equity such as the Portland Global Sustainable Evergreen Fund, and alts such as Toronto-based farmer land-lease provider Bonnefield Inc.

Ripoll’s sample portfolios

ETF Ticker MER Allocation Asset class
iShares ESG MSCI USA Leaders Index ETF XULR 0.20%* 30% Equities
iShares ESG Advanced 1–5 Year Canadian Corporate Bond Index ETF XSHG 0.15%* 30% Fixed income
BMO MSCI Canada ESG Leaders Index ETF ESGA 0.17% 20% Equities
Horizons Global Sustainability Leaders Index ETF ETHI 0.54% 10% Equities
BMO Clean Energy Index ETF ZCLN 0.35%* 10% Equities

Nash’s sample portfolios

For ESG-tilted investors
ETF Ticker MER Allocation Asset class
iShares ESG Balanced ETF Portfolio GBAL 0.24% 75% Hybrid (63.6% equity and 36.1% fixed income)
AGF Global Sustainable Growth Equity ETF AGSG 0.65%* 15% Equities
EcoCharge Green Bond N/A N/A 10% Fixed income
For “greener” ETF investors
ETF Ticker MER Allocation Asset class
Horizons Global Sustainability Leaders Index ETF ETHI 0.54% 40% Equities
BMO Government Bond ETF ZGB 0.17% 30% Fixed income
CI MSCI World ESG Impact ETF Unhedged CESG.B 0.58% 20% Equities
Fair Finance Fund N/A N/A 10% Social finance