As little as forty years ago, stocks and bonds were mostly transacted in trading pits between human beings barking at one another. Successful transactions were recorded on paper and the system relied on physical stock certificates to track who owned what. Transaction/commission costs were high, spreads (the profit collected by the market maker for matching buyers with sellers) were wide, liquidity was thin, and transparency was low. Summed together, constructing a basket of securities even loosely resembling a diversified investment portfolio was very expensive…

Customization

Technology and innovation has changed everything. Electronic trading, book entry (digital recordkeeping of investor ownership), and computing enhancements led to the advent of mutual funds and Exchange Traded Funds (ETFs) that can now deliver broad diversification at low cost. For some investors, though, broad diversification using index-based funds means investing in (and thus, “supporting”) companies that they would rather not, such as British American Tobacco and Smith & Wesson, and customization – the ability to filter out companies or industries that fall short of ethical alignment – would be icing on an otherwise beautifully diversified cake.

B|O|S has paid careful attention to developments in so-called Socially Responsible Investing (SRI), which is also referred to as Environmental, Social, and Governance, or ESG investing for short. While we have long approved of a select group of SRI mutual funds with predetermined ESG-related filters, we have recently expanded our offering to include full customization. In simple terms, we now have the ability to utilize institutional investment managers to construct customized groups of individual stocks and bonds to represent the major pieces (or in financial jargon, asset classes) of a B|O|S managed portfolio. For example, instead of using the Vanguard 500 Index Fund to represent a portfolio allocation to U.S. large company stocks, a customized basket of stocks that are both included in the index (in this case, the S&P 500 Index) and align with selected filters (e.g. no oil, no tobacco, high ranks on corporate governance) is used as a replacement. Much like dining at a restaurant, clients can pass on the prix fixe menu and order a la carte.

While seemingly utopian, there are many important caveats. First, high minimums are required for each asset class, which makes the approach only accessible to larger portfolios. Second, investment costs associated with customized approaches are modestly higher than more standard B|O|S approaches devoid of any ESG-related filters. Third, imbedded capital gains can make a transition prohibitively expensive. Fourth, portfolios with ESG filters are less diversified than portfolios without these screens. And last, but certainly not least, customization of a given asset class creates so-called “tracking error” relative to the returns of the respective benchmark index. For example, a basket of U.S. large company stocks that excludes oil, coal, and tobacco companies but is otherwise constructed to track the S&P 500 index, will under- or out-perform the index based on the relative returns of these excluded companies. Tracking error measures the magnitude of this variance from the benchmark.

Typically, more screens, more tracking error. However, that isn’t necessarily the case as different screens have different correlations, relative to one another, and the underlying asset manager will adjust weightings to the surviving group of securities (i.e. those not screened out) in an effort to reduce projected tracking error as much as possible. From our perspective, it’s all about expectations and transparency. Investors that utilize a customized SRI strategy must understand and accept that their returns will vary (positively or negatively) from the returns of the major benchmarks.

Ultimately, the goal of any SRI strategy should not be to outperform a non-SRI portfolio. Rather, the goal should be to achieve closer alignment between the portfolio’s underlying holdings and the investor’s values while limiting the extra costs and tracking error associated with the more customized SRI approach. We think this is best achieved through a framework that allows customization – via filters tailored to meet a client’s investment objectives – within an overall approach that prioritizes diversification, tax efficiency, and low cost.

If you are interested in SRI and want to explore potential strategies, please contact your advisory team at B|O|S. We’re happy to discuss this approach with you in light of your specific goals and circumstances.

Filed under: Investing

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