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Why Direct Indexing May Be The Best Way To Incorporate ESG

By Barrett Ayers, President

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Advisors have been struggling for decades to construct an investment plan for their clients that is consistent with their personal preferences without compromising on performance or time. Many claim that there are a variety of ways to incorporate ESG considerations into clients’ investment portfolios. However, we at Adhesion Wealth believe some methods pale in comparison to the direct indexing approach and do not provide a true representation.

In this blog, we introduce you to the two main ways through which advisors currently approach ESG investing. We also explain why we consider these strategies to be inferior to the direct indexing route.

Divestment & Exclusionary Investing

The most obvious way to take ESG criteria into account is by excluding certain securities from an investment portfolio because they do not adhere to the client’s personal preferences and/or values.

Most advisors typically start with an investment account, such as a large cap growth model with 30 stocks used for clients with similar risk profiles. If a client then states that they do not want to invest in stocks that fail to adhere to certain environmental and sustainability standards, the advisor pulls out any stocks that do not match those values.

Let’s say 10 of the 30 stocks within the large cap strategy are no longer investable for that client. The client is now left with a group of 20 stocks that no longer make sense together and certainly do not correlate to the benchmark or the client’s risk profile. The initial model was constructed with a specific risk profile and performance objective in mind. This goal is no longer achievable without the stocks that were removed due to the client’s ESG criteria. For example, the 10 stocks in question may have been a concentration of stocks within a given sector, leaving behind a volatile portfolio that does not meet the risk or reward objectives desired. Further, the remaining 20 stocks will have a performance result that looks very different from the one used by other clients who did not ask for personalization. The result is a meaningful amount of performance dispersion across accounts that are supposed to be managed against a similar risk profile

As ESG becomes more and more popular, these client demands become more frequent. As a result, advisors are constantly creating new combinations of stocks through exclusionary practices based on the individual client’s preferences and values. The end result is far from an ideal solution.

Exclusionary investing has long been the primary way that advisors have tried to adhere to client preferences, but it was clearly inadequate. As a result, advisors turned to ESG thematics managers next.

ESG Thematic Managers

The other approach many advisors turn to for ESG investing is to find a manager that meets your client’s very specific set of criteria, such as low carbon footprint. However, as clients have become increasingly environmentally and socially conscious, the number of concurrent demands has dramatically increased. It has become very difficult to find mutual funds that fit all of these requirements simultaneously. This also makes the advisor’s due diligence process very cumbersome in that quality, history, predictability and experience may no longer be the primary search criteria; instead it’s finding any manager that can meet a series of ESG requirements.

Bottom line, thematic products are not specific enough, given that there is a large spectrum of investment possibilities based on each client’s specific needs and circumstances. There are simply not enough pre-made products out there to satisfy the demand without compromising on fees, risk tolerance, or the quality of the securities.

Direct Indexing: What We Believe Is The Best Way to Incorporate ESG Into Investment Portfolios

Enter direct indexing, the third and arguably best way to incorporate client preferences into an investment portfolio without compromising on performance objectives. Direct indexing allows an advisor to sit with their client and get their very specific ESG criteria in order to construct a customized portfolio. This is an inclusionary approach as opposed to the exclusionary approach detailed above.

A direct index is a portfolio of stocks whose purpose is to track the movement and overall characteristics of an index. The individual investor directly owns the shares and therefore controls the ability to tailor the specific investments. Tracking an index ensures that advisors can more readily fulfill their fiduciary responsibilities by keeping portfolios aligned to their clients’ unique risk profiles and investment objectives. Additionally, advisors and clients can expect very predictable risk and return characteristics.

For example, with direct indexing, you can apply the appropriate ESG modules to an S&P 500 direct index in order to align with the index’s performance while simultaneously adhering to your clients’ values. In other words, direct indexing turns what used to be a weakness associated with portfolio customization into a strength that both the client and the advisor can agree upon.

Conclusion

ESG investing has become increasingly popular. This has created both opportunities and challenges for RIAs associated with developing customized investment strategies depending on their clients’ unique sets of needs and values. Direct indexing allows RIAs to offer a personalized option to their clients while targeting their desired performance, risk, and tax objectives.

That’s why we feel direct indexing is the best way for advisors to incorporate ESG investing into their portfolio construction processes. And, we argue it’s the only efficient, scalable, and manageable option for RIAs to consider.


Want to learn more about direct indexes? Request a consultation with Adhesion Wealth today!

By Barrett Ayers, President