What’s in Your “Green” Portfolio?

In the last decade, we have seen the rise of a major new trend in the investment industry – sustainable investing.  There has been an explosion in the options available to those looking to build a portfolio that aligns with their values.  While we view this trend as a major win for consumers, building a green portfolio may not be as simple as telling your investment manager that you want to select the “sustainable investing option”.  If you really want to make an impact with your investments, it pays to be diligent – the sustainable investing landscape is full of false promises that investors need to be on the lookout for.   This article provides some simple tools to determine whether your sustainable portfolio lives up to the hype, or if it has been greenwashed.

Broadly defined, greenwashing is a misrepresentation by a company or fund provider about their environmental impact.  At the individual company level, greenwashing takes place when companies provide incomplete or misleading information about how their operations impact the environment –whether through carbon emissions, environmental spills, investments in new green technologies, or any other metric. Greenwashing is a spectrum and runs all the way from targeting marketing materials toward environmentally conscious consumers, to outright fraud regarding total carbon emissions.

At the fund level, greenwashing typically takes place when fund providers brand their offerings as sustainable, meanwhile, the holdings in their portfolio are anything but.  In recent years we have had a number of new clients come to us with a “green” portfolio built by a previous advisor.  As part of our onboarding process, we conduct a detailed review of all clients’ portfolios and their underlying holdings.  Occasionally when we review one of these “green” portfolios, we find company names that come as a surprise to us – and to our clients.  Among the holdings in these portfolios, we have seen oil and gas companies, mining companies, arms manufacturers, and companies that have made major headlines for the environmental impact of their water business, their anti-union activity, and their use of child labour.

At the far end of the spectrum, some fund providers in Canada and the US have even greenwashed their existing mutual funds and ETFs by simply taking existing funds and rebranding them as “sustainable” without making a single change to their holdings.  Sometimes these fund providers are generous enough to add a hefty fee bump, now that their portfolio is “sustainable.”  But it’s hard to argue that a portfolio is sustainable when all the holdings were selected without ever taking sustainability into account.

While it may be appropriate for a green fund to include oil, mining, or defense stocks if the methodology allows it, it is not appropriate for a client to be misled on a sustainable portfolio without providing the proper information about the fund’s methodology, or the actual companies it holds.

At Northwood, several of our clients have expressed a strong desire to align their portfolio more closely with their values.  In response, we have built a framework to outline how we think about sustainable investing and performed our own due diligence to find investments that achieve our clients’ goals.  We view sustainable investing as a continuum that extends from purely financial investing to philanthropy, with many steps in between:

In working with our clients to build more these portfolios, we have developed several strategies that we believe can help investors achieve their goals without falling victim to greenwashing.

Understand the Ethical Lens

First, review the fund documents and marketing materials to get a high-level view of the ethical lens being used to make investment decisions.  Does the fund focus solely on minimizing carbon emissions?  Is it an ESG fund (where environmental, social, and governance factors are taken into account)?  Are the ethical decisions being made with a religious lens?  Some of the earliest ethical investment products were built using religious-based criteria and may exclude companies that produce alcohol and tobacco.  It’s important to understand the overall ethical lens of your fund to ensure it aligns with your values, rather than someone else’s.

Understand the Methodology

There is more than one way to build a sustainable portfolio.  Some fund managers choose to build sustainable portfolios by using negative screens – that is, by excluding companies in certain industries such as oil and gas.  Other fund managers choose to build their sustainable portfolios by selecting best-in-class companies from each industry.  Rather than divest entirely from the oil and gas sector, these managers review the environmental records of all energy companies and may allocate to those with the best environmental record, the best safety record, or the largest investment in the transition to renewable energy.  The best-in-class methodology is designed to provide incentives for companies to clean up their act.  If all sustainable investors divest from oil and gas without exception, there may be no incentive for energy companies to invest their resources in reducing emissions or the transition to greener energy sources.

Look Under the Hood

One of the easiest ways to determine if an ethical portfolio is a good fit for you is to take a look under the hood.  The marketing materials for a fund can say just about anything, but the list of top holdings can’t lie.  You can start by reviewing a fund’s fact sheet, which will list the top ten holdings.  If you’re expecting a purely low-carbon portfolio and Suncor is the third or fourth highest-weighted security on the list, you’re probably not getting what you asked for.

If seeing the top ten holdings is not good enough and you want to dig even deeper, you may be able to get more information about fund holdings.  For example, exchange-traded funds (ETFs) typically provide a full list of their holdings, which can be found on the fund provider’s website.  And if you want to dig into individual stocks within a portfolio, providers like Morningstar and Sustainalytics provide more detailed information about sustainability metrics for both individual companies and funds.

Watch Out for Fees

Inevitably, sustainable investing comes with higher fees.  It costs money to review the environmental record of every potential company in the portfolio, or to build an index fund that takes into account the environmental information provided by Morningstar or Sustainalytics.  That can be okay – as long as you know what you’re getting in exchange for your fees.

Here I’d like to focus on index funds.  iShares, a popular ETF provider, has three comparable index ETFs that invest in the broad Canadian stock market.  The management expense ratio (MER) for their largest Canadian index ETF is 0.06%, while the MER for their Canadian market “ESG Aware” and “ESG Advanced” products are 0.17% and 0.16%, respectively.  In this case, the fee drag of ten basis points may be more than worth it to invest in line with your values.  On the other hand, we have seen sustainable index funds with management expense ratios of 1% to 1.5%, or even higher.

It’s more difficult to make broad statements about fees for actively managed sustainable funds.  But, as is always the case, higher fees need to be justified in the context of the service provided.  If you see a sustainable fund with a 2% annual fee and the manager can’t provide clear guidance on how that translates into a superior portfolio with a strong sustainability strategy, there is probably a cheaper, better fund available.

Don’t Let Perfect be the Enemy of the Good

Finally, it’s important to remember that ethics are personal.  One investor may choose to focus on carbon emissions, forced labor, and existential risks.  Another investor may choose to focus on tobacco, alcohol, and firearms.  Even among investors focused on climate as a single issue, there is disagreement about whether to exclude fossil fuels entirely or to take a best-in-class approach to encourage oil companies to invest in green infrastructure.

Perhaps the biggest mistake you can make is to avoid making any changes to your portfolio at all, just because you can’t find an exact fit with your values.  Don’t let perfect be the enemy of the good and take steps toward a greener portfolio today rather than waiting for the perfect product to come along with an exact match to your values.  

One thing is for certain: the explosion in sustainable investing options is long overdue and will continue to reshape the investing landscape for decades to come.  More and more investors are expressing their preference for sustainable investments, and with careful diligence they can avoid these pitfalls to build sensible, well-diversified portfolios that meet their ethical standards.