Behind the veils of direct indexing and ESG portfolio management

Since the inception of the Sullivan Principles in 1977, responsible investors have sought to employ techniques to avoid investing in public companies that fail to mirror their mission, values, and beliefs. Today, investors of all sizes are ready to go beyond screening for misalignment with values by proactively incorporating positive impact guardrails into their portfolio. Positive impact investing is thought to include sustainable and socially ethical practices, such as sustainable forestry, clean technology, affordable housing, green urban development and sustainable farming.

Mission-driven investing it is no longer a nice-to-offer, it is a must-have. Everywhere you look, investors and advisers are discussing the importance of ESG and assessing how to implement it most effectively for their clients. According to a Global Impact Investing Network survey in 2020, 69% — a clear majority — of the 294 respondents consider the impact investing market to be “growing steadily,” with 21% describing the market as “about to take off.” Zero respondents saw the impact investing market “declining.” 

Responsible investors are seeking to create portfolios emphasizing positive impact, as opposed to simply avoidance. The desire in the industry is clear, and it’s our fiduciary duty to deliver options that will result in similar financial returns, which investors of course continue to expect.

BUILDING BLOCKS

Positive impact portfolios may be built by focusing on investing in companies meeting guidelines for best practices in responsible investing, such as those established by the 4,000 signatories of the Principles for Responsible Investment, and may include any number of diverse factors, such as the 17 UN Sustainable Development Goals. When building these portfolios, start with a global equity index designed by a large commercial index provider. For example, our initial list of candidates for our positive impact portfolio comprised over 1,600 large- and mid-cap stocks drawn from 23 developed markets globally.

STARTING POINT: NEGATIVE SCREENS

To build our positive impact portfolio, we begin (strangely enough) by employing negative screens. The thought is that no positive impact portfolio should contain stocks that conflict with investor values and beliefs. We employ 14 negative screens, including commonly used screens for investor values, as well as screens to eliminate ESG “laggards” (stocks with the lowest three tiers of ESG rankings). We screen out companies with failed compliance with the United Nations Global Compact Principles, the United Nations Guiding Principles for Business and Human Rights and the International Labor Organization’s labor standards. We screen out companies involved in commercial factory farming and for-profit prisons. Lastly, we screen out companies with notable controversies related to their operations or products.

NEXT STEPS: POSITIVE SCREENS

We use the 17 United Nations SDGs to rigorously measure the relative positive impact of each of the remaining 1,100 stocks. The SDGs include social goals such as no poverty, zero hunger, quality education, good health and well-being, and affordable housing. They also include environmental goals such as clean water, clean energy, climate action, life on land and below water, and responsible consumption and production. Finally, they include social justice goals, such as gender equality, decent work and economic growth, and reduced inequities.

With this information in hand, we eliminate all companies that don’t derive a minimum of 40% of their revenue from business activities that support one or more of the UN SDGs. We rank each of the remaining candidates using a scale of -10 to +10 across each of the 17 SDGs and then eliminate all equities that fail to score at least a 0 — the halfway point — on the scale. These steps eliminate an additional 1,004 stocks.

Overall, we employ 34 distinct screens for our positive impact portfolio — both negative and positive — to arrive at our list of 79 finalists out of a starting pool of over 1,600. These 79 companies represent the best of the best in terms of providing strong positive impact in large- and mid-cap stocks in developed markets. But we’re not yet finished with our portfolio’s construction.

TRADING ISSUES

With our positive impact finalists in hand, we still must ensure the portfolio is tradable, that is, that the foreign stocks offer American Depositary Receipts that we can trade in lieu of their foreign ordinary shares, and that all shares have at least a minimum trading volume. We find a total of 32 “trading fails” out of the 79 finalists; 13 for lack of an available ADR and 19 that trade less than our minimum daily trading volume.

Like whittling a solid block of wood into a recognizable shape, we have winnowed our initial opportunity set down to the best-in-class, tradable companies for positive global impact.

PORTFOLIO WEIGHT AND OPTIMIZATION TARGET

Next, we set limits to ensure diversification by requiring that each stock represent at least one-half of one percent (0.50%), but not more than five percent (5.00%), of our positive impact portfolio.

Finally, we tackled the issue of which benchmark to use as an optimization target. Given the exceptionally high degree of exclusions we have made from the benchmark and the variability in ESG ratings among commercial rating services, we determined to optimize to a more meaningful target for our purposes, which was optimizing the percent of revenues tied to one or more SDG goals in our portfolio.

We accomplish this in two ways — first, by constraining our optimization to ensure the aggregate portfolio derives at least 75% of its revenues from one or more of the SDGs, and second, by optimizing the relative weightings inter se, tilting toward companies with higher percentages of revenue tied to SDG goals relative to those with lower percentages.

INVESTING FOR TOMORROW

We’ve come a long way since the Sullivan Principles in the 1970s. Today there’s no denying the rising demand for positive impact portfolios. The movement has begun, and the desire for this type of direct indexing is only going to grow as we move forward into the future. Clients of all kinds — whether it’s an endowment or wealth management firm — need to follow the wishes of those they serve. Investors and institutions alike are already pressed for time and need a dedicated partner to enact a thoughtful direct indexing approach to building client portfolios on their behalf.

Your clients want to make a positive impact with their investments.  Are you ready to help?

Dennis Hammond is head of responsible investment at Veriti Management.

Related Topics: Sustainable Investing