Creating a Sustainable Portfolio: Balancing Financial and Ethical Goals

If you are an investor who cares about the planet and the society, you might be interested in creating a sustainable portfolio. A sustainable portfolio is a collection of investments that meet certain environmental, social, and governance (ESG) standards, while also delivering competitive financial returns.

By investing in a sustainable portfolio, you can align your money with your values, and contribute to positive change in the world.

But how do you balance your financial and ethical goals in investing? How do you ensure that your portfolio is both profitable and responsible?

And what are the benefits and challenges of creating a sustainable portfolio? In this article, we will answer these questions and provide you with some practical guidance on how to create a sustainable portfolio that suits your needs and preferences.

What is a Sustainable Portfolio and Why is it Important?

Definition and examples of a sustainable portfolio

A sustainable portfolio is a portfolio that incorporates ESG criteria into the investment decision-making process. ESG criteria are a set of standards that evaluate the environmental, social, and governance performance of a company or a fund.

For example, environmental criteria may include factors such as carbon emissions, water usage, waste management, and renewable energy. Social criteria may include factors such as human rights, labor practices, diversity, and community engagement. Governance criteria may include factors such as board structure, executive compensation, shareholder rights, and business ethics.

By applying ESG criteria, investors can screen out companies or funds that have negative impacts on the environment or the society, and select those that have positive impacts or demonstrate leadership in sustainability.

For instance, a sustainable portfolio may exclude investments in fossil fuels, tobacco, weapons, or gambling, and include investments in clean energy, health care, education, or social justice. Some examples of sustainable funds and ETFs that you can invest in are:

-Vanguard ESG U.S. Stock ETF (ESGV): This ETF tracks the performance of the FTSE US All Cap Choice Index, which excludes companies that do not meet certain ESG standards, such as those involved in adult entertainment, alcohol, tobacco, weapons, fossil fuels, gambling, and nuclear power.

– iShares ESG Aware MSCI USA ETF (ESGU): This ETF tracks the performance of the MSCI USA Extended ESG Focus Index, which selects and weights companies based on their ESG ratings, while maintaining a similar risk and return profile to the broader market.

– SPDR S&P 500 ESG ETF (EFIV): This ETF tracks the performance of the S&P 500 ESG Index, which selects and weights companies based on their ESG scores, while excluding those that have low ESG ratings or are involved in controversial activities, such as tobacco, thermal coal, or weapons.

The rise of environmental, social, and governance (ESG) criteria in investing

ESG criteria have become increasingly important and popular in the investment world, especially in the last decade. According to the Global Sustainable Investment Alliance, the global sustainable investment assets grew by 15% from 2016 to 2018, reaching $30.7 trillion.

Moreover, a survey by Morgan Stanley found that 85% of individual investors and 95% of millennial investors are interested in sustainable investing.

There are several reasons why ESG criteria have gained more attention and traction among investors. First, there is a growing awareness and concern about the environmental and social challenges that we face today, such as climate change, pollution, inequality, poverty, and human rights violations.

Many investors want to use their money to support solutions to these problems, and avoid contributing to their causes. Second, there is a growing recognition that ESG factors can have a significant impact on the financial performance and risk management of companies and funds.

Many studies have shown that companies and funds that score high on ESG metrics tend to outperform their peers, and have lower volatility, lower costs of capital, and higher resilience to market shocks.

Third, there is a growing demand and expectation from various stakeholders, such as customers, employees, regulators, and shareholders, for companies and funds to disclose and improve their ESG performance and practices. Many investors want to align their investments with their values, and hold companies and funds accountable for their ESG impacts.

The impact of sustainability on financial performance and risk management

One of the main questions that investors have when it comes to sustainable investing is whether it can deliver competitive financial returns.

Some investors may have the misconception that sustainable investing means sacrificing returns for values, or that it is only suitable for philanthropic or ethical purposes. However, this is not the case. In fact, sustainable investing can offer both financial and ethical benefits, and there is no trade-off between the two.

Numerous studies have shown that sustainable investing can generate higher returns, lower risks, and better long-term outcomes than conventional investing. For example, a meta-analysis by Friede et al. (2015) reviewed more than 2,000 empirical studies on the relationship between ESG and corporate financial performance, and found that the majority of studies reported a positive or neutral correlation.

Similarly, a report by Morningstar (2020) analyzed the performance of more than 4,900 sustainable funds and ETFs, and found that they outperformed their non-sustainable peers in 2019, and also during the market downturn caused by the COVID-19 pandemic in the first quarter of 2020.

Moreover, a study by Khan et al. (2016) examined the impact of ESG issues on the future earnings of more than 2,000 US companies, and found that companies with high ratings on material ESG issues (those that are relevant and important for their industry) had higher future earnings, while those with low ratings had lower future earnings.

The reason why sustainable investing can enhance financial performance and risk management is that ESG factors can affect the value drivers and competitive advantages of companies and funds.

For example, environmental factors can affect the operational efficiency, resource availability, regulatory compliance, and reputation of companies and funds.

Social factors can affect the customer loyalty, employee engagement, innovation, and social license of companies and funds. Governance factors can affect the strategic direction, accountability, transparency, and stakeholder relations of companies and funds.

By incorporating ESG criteria into the investment process, investors can identify and capitalize on the opportunities and strengths of companies and funds that are well-managed and well-positioned for sustainability, and avoid or mitigate the risks and weaknesses of those that are poorly-managed and poorly-positioned for sustainability.

How to Balance Financial and Ethical Goals in Investing?

The trade-off between returns and values

While sustainable investing can offer both financial and ethical benefits, it does not mean that there is no trade-off between the two. Sometimes, investors may face a dilemma between maximizing their returns and adhering to their values.

For example, an investor who is concerned about climate change may want to invest in renewable energy, but may also find that fossil fuel companies offer higher dividends or growth potential.

Or an investor who is passionate about social justice may want to invest in companies that promote diversity and inclusion, but may also find that some of these companies are involved in controversial practices, such as tax evasion or human rights violations.

How can investors resolve this trade-off and balance their financial and ethical goals in investing? There is no one-size-fits-all answer to this question, as different investors may have different preferences, priorities, and constraints. However, there are some general steps that investors can take to make informed and balanced decisions. These steps are:

• Define your financial and ethical goals: The first step is to clarify what you want to achieve with your investments, both financially and ethically. For example, you may have a specific target return, risk tolerance, time horizon, or income requirement for your portfolio. You may also have a specific set of values, beliefs, or causes that you want to support or avoid with your investments. By defining your financial and ethical goals, you can narrow down your investment options and criteria, and avoid being influenced by irrelevant or conflicting factors.

• Assess your current portfolio: The second step is to evaluate how your current portfolio aligns with your financial and ethical goals. You can use various tools and methods to measure the performance, risk, and sustainability of your portfolio, such as financial ratios, benchmarks, ratings, scores, or reports. You can also compare your portfolio with other portfolios that have similar or different financial and ethical goals, and see how they differ in terms of returns, volatility, diversification, and impact. By assessing your current portfolio, you can identify the gaps and areas for improvement, and decide whether you need to make any changes or adjustments.

• Choose your sustainable investing strategy: The third step is to select the sustainable investing strategy that best suits your financial and ethical goals. There are different ways to incorporate ESG criteria into your portfolio, depending on how much you want to emphasize or compromise on your returns or values. The spectrum of sustainable investing strategies ranges from exclusion to impact, as shown below:

Implement and monitor your sustainable portfolio: The final step is to execute and review your sustainable portfolio. You can use various platforms, tools, and services to help you build, manage, and optimize your sustainable portfolio, such as robo-advisors, online brokers, or financial advisors.

You can also use various sources, channels, and networks to help you stay informed and updated on the latest developments and trends in sustainable investing, such as newsletters, podcasts, blogs, or forums. By implementing and monitoring your sustainable portfolio, you can ensure that it meets your financial and ethical goals, and make any necessary changes or adjustments along the way.

What are the Benefits and Challenges of Creating a Sustainable Portfolio?

The advantages of investing in a sustainable portfolio

Investing in a sustainable portfolio can offer you several advantages, both financially and ethically. Some of the advantages are:

• Higher returns: As we have seen, sustainable investing can generate higher returns than conventional investing, as ESG factors can enhance the value drivers and competitive advantages of companies and funds. Moreover, sustainable investing can also benefit from the growing demand and support for sustainability from various stakeholders, such as customers, employees, regulators, and shareholders, which can create new markets, opportunities, and incentives for sustainable companies and funds.

• Lower risks: Sustainable investing can also lower your risks, as ESG factors can reduce the exposure and vulnerability of your portfolio to ESG risks, such as environmental disasters, social unrest, or governance scandals. Moreover, sustainable investing can also improve your risk management, as ESG factors can increase the transparency, accountability, and resilience of your portfolio, and help you anticipate and mitigate potential ESG issues or shocks.

• Better alignment: Sustainable investing can also help you align your portfolio with your values, beliefs, and causes, and make you feel good about your investments. By investing in a sustainable portfolio, you can express your preferences and opinions on ESG issues, and support or avoid companies and funds that have positive or negative impacts on the environment or the society. Moreover, sustainable investing can also help you align your portfolio with your personal and social objectives, and contribute to positive change in the world.

The obstacles and limitations of sustainable investing

However, investing in a sustainable portfolio is not without challenges and limitations. Some of the challenges and limitations are:

• Data and disclosure: One of the main challenges of sustainable investing is the lack of consistent, reliable, and comparable data and disclosure on ESG performance and practices of companies and funds. There are different sources, methods, and standards for measuring and reporting ESG information, which can create confusion, inconsistency, and incomparability among investors. Moreover, some companies and funds may not disclose their ESG information at all, or may disclose only selective or misleading information, which can limit the availability and accuracy of ESG data and disclosure.

• Performance and impact: Another challenge of sustainable investing is the uncertainty and variability of the performance and impact of sustainable investments. There is no guarantee that sustainable investments will always outperform or have positive impacts, as ESG factors can have different effects on different companies, funds, sectors, and markets, depending on various factors, such as the materiality, relevance, and timing of ESG issues. Moreover, some sustainable investments may have trade-offs or unintended consequences, such as negative externalities, opportunity costs, or displacement effects, which can reduce or negate their performance or impact.

• Complexity and diversity: A third challenge of sustainable investing is the complexity and diversity of the sustainable investing landscape. There are different definitions, approaches, and strategies for sustainable investing, which can make it difficult for investors to understand and navigate the sustainable investing field. Moreover, there are different preferences, priorities, and constraints for sustainable investing, which can make it hard for investors to find and select the sustainable investments that match their financial and ethical goals.

Conclusion

Creating a sustainable portfolio is a rewarding and meaningful way to invest your money, as it can offer you both financial and ethical benefits. By incorporating ESG criteria into your portfolio, you can enhance your returns, lower your risks, and align your portfolio with your values and objectives.

However, creating a sustainable portfolio is also a challenging and complex process, as it requires you to balance your financial and ethical goals, and overcome the obstacles and limitations of sustainable investing.

Therefore, you need to be informed, prepared, and flexible when creating a sustainable portfolio, and follow the best practices and tips that we have provided in this article. We hope that this article has helped you understand and appreciate the concept and importance of creating a sustainable portfolio, and inspired you to take action and start your sustainable investing journey.

FAQs

What are some of the best sustainable funds and ETFs to invest in?

There is no definitive answer to this question, as different sustainable funds and ETFs may have different objectives, criteria, performance, and impact. However, some of the factors that you can consider when choosing the best sustainable funds and ETFs are:

• The ESG approach and strategy of the fund or ETF: You should check how the fund or ETF incorporates ESG criteria into its investment process, and whether it aligns with your sustainable investing strategy, such as exclusion, integration, thematic, or impact.
• The ESG rating and score of the fund or ETF: You should check how the fund or ETF performs on ESG metrics, and whether it has a high or low ESG rating or score, based on various sources, such as Morningstar, MSCI, or Sustainalytics.
• The financial performance and risk of the fund or ETF: You should check how the fund or ETF performs on financial metrics, such as returns, volatility, fees, and diversification, and whether it has a competitive or superior financial performance and risk profile, compared to its peers or benchmarks.
• The impact and disclosure of the fund or ETF: You should check how the fund or ETF measures and reports its impact on the environment or the society, and whether it has a positive or negative impact, based on various indicators, such as carbon footprint, social impact, or ESG controversies.

How can I measure the sustainability of my portfolio?

There are various tools and methods that you can use to measure the sustainability of your portfolio, such as:

• ESG portfolio analysis: You can use online platforms, such as Morningstar, MSCI, or Sustainalytics, to analyze the ESG performance and practices of your portfolio, and compare it with other portfolios or benchmarks. You can also get an ESG rating or score for your portfolio, based on various ESG criteria and metrics.
• ESG portfolio reporting: You can use online platforms, such as Impakt, Ethic, or YourSRI, to generate an ESG report for your portfolio, and get a detailed and comprehensive overview of your portfolio’s ESG performance, impact, and exposure. You can also get recommendations and suggestions for improving your portfolio’s ESG performance and impact.
• ESG portfolio optimization: You can use online platforms, such as OpenInvest, Earthfolio, or Swell, to optimize your portfolio’s ESG performance and impact, and get a customized and personalized portfolio that matches your financial and ethical goals. You can also get feedback and guidance for managing and adjusting your portfolio’s ESG performance and impact.

How can I diversify my portfolio across different ESG themes and sectors?

Diversifying your portfolio across different ESG themes and sectors can help you reduce your risks, increase your opportunities, and enhance your impact. Some of the ways that you can diversify your portfolio across different ESG themes and sectors are:

• Invest in thematic funds and ETFs: You can invest in thematic funds and ETFs that focus on specific ESG themes or sectors, such as clean energy, health care, education, or social justice. You can choose the themes or sectors that interest you or align with your values and objectives, and diversify your portfolio across them.
• Invest in multi-theme funds and ETFs: You can invest in multi-theme funds and ETFs that cover a range of ESG themes or sectors, such as climate change, gender equality, human rights, or innovation. You can get exposure to multiple ESG themes or sectors with a single fund or ETF, and diversify your portfolio across them.
• Invest in diversified funds and ETFs: You can invest in diversified funds and ETFs that invest in a broad and balanced portfolio of companies or funds that meet certain ESG standards or criteria, such as ESG leaders, ESG improvers, or ESG best-in-class. You can get exposure to various ESG themes or sectors with a diversified fund or ETF, and diversify your portfolio across them.

How can I avoid greenwashing and other misleading claims in sustainable investing?

Greenwashing is the practice of making false or exaggerated claims about the environmental or social benefits of a product, service, or investment, in order to deceive or mislead consumers or investors. Greenwashing is a common and serious problem in sustainable investing, as some companies or funds may use ESG labels, terms, or symbols, without actually having a genuine or substantial commitment or impact on ESG issues. Some of the ways that you can avoid greenwashing and other misleading claims in sustainable investing are:

• Do your research: You should do your own research and due diligence on the companies or funds that you are interested in investing in, and verify their ESG performance and practices, using various sources, such as financial statements, sustainability reports, ESG ratings, or third-party audits. You should also check the credibility and reputation of the ESG providers, platforms, or advisors that you use, and ensure that they are independent, transparent, and consistent.
• Ask questions: You should ask questions and seek clarifications on the ESG claims and statements that you encounter, and challenge any vague, ambiguous, or contradictory information. You should also ask for evidence and examples of the ESG performance and impact of the companies or funds that you are interested in investing in, and compare them with their peers or benchmarks.
• Be skeptical: You should be skeptical and critical of the ESG claims and statements that you encounter, and not take them at face value. You should also be aware of the common signs and indicators of greenwashing, such as:

• Using ESG labels, terms, or symbols, without providing clear definitions, explanations, or standards for them.
  • Making vague, general, or unsubstantiated claims about ESG performance or impact, without providing specific, measurable, or verifiable data or evidence for them.
  • Highlighting positive or selective ESG aspects, while ignoring or hiding negative or material ESG aspects.
  • Claiming to be aligned or compliant with ESG frameworks, guidelines, or regulations, without actually following or meeting them.
  • Claiming to have ESG goals, policies, or initiatives, without actually implementing or achieving them.

How can I stay updated on the latest trends and developments in sustainable investing?

Sustainable investing is a dynamic and evolving field, and there are always new trends and developments that you need to be aware of and adapt to. Some of the ways that you can stay updated on the latest trends and developments in sustainable investing are:

• Follow the news and media: You can follow the news and media outlets that cover sustainable investing topics, such as The Financial Times, The Wall Street Journal, Bloomberg, or Forbes. You can also subscribe to newsletters, podcasts, blogs, or magazines that focus on sustainable investing, such as GreenBiz, ImpactAlpha, or Responsible Investor.
• Follow the research and reports: You can follow the research and reports that provide insights and analysis on sustainable investing, such as those published by academic institutions, think tanks, or consulting firms. You can also access the databases, indices, or rankings that track and compare the ESG performance and impact of companies and funds, such as those provided by Morningstar, MSCI, or Sustainalytics.
• Follow the events and networks: You can follow the events and networks that offer opportunities and platforms for learning and networking on sustainable investing, such as conferences, webinars, workshops, or forums. You can also join the communities, groups, or associations that connect and support sustainable investors, such as the Global Sustainable Investment Alliance, the Principles for Responsible Investment, or the CFA Institute.