Demand for environmental, social and governance investing has remained robust despite a host of concerns, including greenwashing and fund managers inflating, or downright misrepresenting, the sustainability credentials of their ESG products. Intensifying this dynamic is a prevailing lack of consistency and standardization around ESG nomenclature and data inputs, with some funds using criteria so broad and opaque that an investor is unlikely to see their needs met.
Yet clients, whether motivated purely by potential risk mitigation, their wish to advance causes that are meaningful to them, or somewhere in between those two poles, remain interested in ESG strategies. Indeed, research indicates that advisors may be underestimating the demand. So how do financial advisors navigate these murky waters on behalf of their clients? We suggest that direct indexing can help mitigate risk and create a portfolio that addresses a client's needs no matter where they fall on the ESG enthusiasm spectrum.
Since values are inherently personal, much of the criticism around ESG stems from the perception that large asset managers are imposing their views on the investing public. That's because widely marketed index funds, featuring vague "green" or "ESG"labels, tend to represent a monolithic solution to various societal ills. It's often difficult for investors to discern how the likes of Exxon Mobil — both a known polluter and major backer of renewable energy research and development — could possibly be considered for inclusion in a "green"fund. Or to fathom how Tesla, considered by many an environmental darling for its role in accelerating adoption of electric vehicles, can be kicked out of an ESG index for its social and governance transgressions.
Who, investors wonder, is making these decisions — and why? or mutual funds, the investor directly owns the underlying holdings of a given index and can therefore customize it to reflect the factors that they deem most important — including, but not limited to their environmental, social and governance priorities. If an investor wants to forgo fossil fuel producers, avoid aerospace companies or circumvent controversial weapons, they have the ability to do so. Outdoor clothing retailer Patagonia, for example, was able to create a customized retirement plan that closely tracks the Russell 3000 Index while forswearing fossil fuels, mining and other extractive companies.
The benefits of direct indexing don't stop with ESG strategies. Investors with concentrated stock holdings — for instance a tech executive with wealth tied up in an employee stock plan — can manage concentration risk by screening out their employer's stock during the portfolio construction process.
They might also choose to implement factor tilts, focusing on desirable stock characteristics such as momentum or value. And since investors own the underlying securities in an index and not a pooled fund, they can avail themselves of tax-loss harvesting technology to isolate losing stocks and offset or defer capital gains on highly appreciated positions. This can prove especially compelling in volatile markets; in some instances, the after-tax returns can actually offset and supersede any fees incurred.
Direct indexing fosters transparency, helping advisors work with clients to define a portfolio that feels meaningful to them. Further, as clients' values and worldviews evolve over time, they can customize their portfolios accordingly in a way that simply isn't possible with an off-the-shelf index fund.
Today's clients increasingly expect an experience that reflects their unique needs and goals. A direct indexing framework can serve as a springboard for meaningful discussions that help advisors understand what matters most to their client and then act on that information accordingly. Advisors that take the time to understand their clients' fundamental belief systems and inner motivations will be well positioned to demonstrate lasting value.