ESG investing is getting personal

Morningstar’s Arnold says direct indexing is the evolution of ESG investing

Paul Arnold


Paul Arnold, co-head, asset allocation strategies, Morningstar IM

Over the course of the last decade, investors have experienced a proliferation of ESG investment offerings that aim to address the mass-market desire for personalization.

Indeed, it doesn’t get more personal in the investing world than ESG, which implicitly aims to align an investment objective with an investor’s personal values.

The latest exciting development in this space is direct index offerings, which follow a recent development curve that started with core passive ESG offerings, quickly moved to thematic funds and ETFs and has more recently expanded to active ownership/engagement (not just active management!).

While the sequence and depth of development has space for further progress, each vintage has been warmly welcomed.

Evolution of ESG offerings

Starting with the low-hanging fruit, passive ESG offerings have now hit a maturity point and are fairly well developed.

Investors that would like to invest in the ESG version of a traditional benchmark (think S&P 500) with low tracking error can readily find accessible options. In fact, many are now available for only a marginally incremental expense.

Despite a few shortcomings, such as being at the mercy of the index providers’ definition of ESG bona fides, these broad-market ESG index-based products allow for the subtle integration of an investor’s values into their investment decision.

They are also often cheaper and therefore an effective way of dipping one’s toes into the sustainable investing pool.

For the folks who want to own their exposures a bit more, thematic index-based products provide even more personalization and can be used to help enhance the sustainability profile of a client’s nest egg.

Do you care about clean energy? Agriculture? Water? Low carbon? Gender diversity? Investible ETFs focused on companies in these areas are available to you right now.

Then came the expansion of active ownership and portfolio company engagement.

Up until recently, the only other mainstream option for sustainably-focused investors has been the selection of an active fund manager who is aligned with your values.

Active management in the ESG space allows for a portfolio approach that many clients are used to, but it adds the critical advantage of active ownership—with proxy voting being an underrated component of values-based investing.

Managers of concentrated strategies can add a focus on engagement and impact, pushing their underlying holding companies to manage ESG risk and proactively improve their sustainability profile.

In choosing active managers who align with the values of an investor, they are getting a double punch of active management and active personalization.

Eye to the future

Innovation is the lynchpin of our global economy. It is required to transition us toward meeting the climate goals necessary to avoid a forecasted catastrophe.

Similarly, technological advancement is a requirement of a functioning economy in order to achieve growth.

Direct indexing, which is rapidly barreling towards an expected offering for all investment platforms, with high forecast growth rates, is a great example of innovation in the investment space.

The simple description of direct indexing is that it offers an investor an individual portfolio of stocks that seeks to track a specific index.

Trading software, fractional share ownership, and advanced portfolio optimization software have all advanced to the point where this solution can be offered as a scalable, cost-effective solution for retail clients.

The ability to tailor an index-based product to your personal values fills an important void in the existing sustainable portfolio offerings above.

With traditional passive and active investment offerings, you have no inherent seat at the table in determining what is held in your fund.

Proprietary ESG scores and methodologies, as well as decisions of active portfolio managers to invest/divest, prevent a complete personalization of one’s values.

With direct indexing, an investor can start with a traditional (or ESG) index-based product and add a personalized overlay, specifying sectors, industries, sub-industries and even companies that they wish to avoid.

Direct indexing won’t be the end of investment innovation, but it fills a large gap by providing active personalization in the ESG space that clients continue to demand. 

In an industry that has historically thrived on telling consumers what is right for them, values-conscious investors have never had as much active control over how their portfolios are invested.

A full spectrum of ESG personalization now exists that puts the investor in control of their path to achieve their financial goals.

Whether one is interested in a similar experience to a traditional portfolio, an issue-specific focus, a fully customized exclusion/inclusion direct index offering, or an active-fund approach, sustainable investing provides a roadmap for the personalization revolution.  

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