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Combining Two of The Hottest Trends in Investing: SRI/ESG Investing And Direct Indexing

SRI/ESG* investing is one of the fastest-growing movements in wealth management and shows no signs of stopping. In fact, there has been a 38% increase since 2016, and it now comprises 25% of all assets under management in the U.S. Moreover, 75% of investors indicate interest in SRI/ESG investing. Another rising trend is direct indexing, which allows advisors to build personalized, transparent portfolios of individual securities for clients based on indexes or model portfolios. With direct indexing, advisors can use their financial savvy to construct unique compilations of individual securities that include or exclude particular industries, stocks, sectors, and more – such as SRI/ESG overlays.

Folio Institutional_Direct Indexer Blog with SRI_Percents

of assets under management in the U.S. are focused on SRI/ESG.

Folio Institutional_Direct Indexer Blog with SRI_Percents (1)

of investors indicate interest in SRI/ESG investing


Trends in SRI/ESG Investing

SRI/ESG investing started small and with a compelling idea:  that aligning purpose to profit was the right thing to do. There were no data or framework, or even any impact investing products. The prevailing wisdom at the time dictated that SRI/ESG investing was a passing fad that would never be able to reap the financial rewards that mainstream investing could. Interest seemed to spike around certain newsworthy topics, such as Apartheid in South Africa and disasters like the Exxon Valdez, but never electrified the masses on a consistent basis. Until now.

At $12 trillion, SRI/ESG investing is primed to become the most significant force in social transformation for the foreseeable future. A pivotal change came in the late 1990s and early 2000s with the emergence of more data showing that SRI/ESG investing was indeed profitable. Results from Global Impact Investing Network’s 2019 Impact Investor Survey indicate that the financial rewards reaped from impact investing are in line with traditional investing 77% of the time, and in 14% of cases actually outperform them, regardless of impact discipline or filter.

SRI/ESG’s emerging importance is magnified by ever-increasing focus in the media, among legislative bodies and businesses, and in the public at large around social and environment issues. For example, despite a traditional lack of focus in news coverage on climate change – a Project For Improved Environmental Coverage report cites that only 1-2% of news coverage was focused on the issue in 2012 – a recent headline from The New York Times, which has added an “environment” section to its publication, declared “As the World Heats Up, the Climate for News Is Changing, Too.” An increase in legislation has meant that businesses have to disclose the environmental impact of their operations, which has further mainstreamed sustainability. Finally, investors have gone from just talking about wanting to put their money where their values are to actually doing it, as witnessed by the statistics mentioned in this blog.

The Advantages of Direct Indexing

With direct indexing, advisors can either create a portfolio of securities that replicate an index or create their own personalized index that includes, excludes, or limits particular industries, stocks, sectors, geographies, preferences, and values. For example, if a client has concentrated stock in Apple because they work there and are overexposed in the technology industry, advisors could exclude both stock and industry. Or, if clients want to include specific companies (e.g., women-led businesses) in their portfolio, they can do that as well.

The primary benefits of direct indexing revolve around the following three factors: 

  • Customization. Direct indexing offers the ability to tailor investment choices for a variety of factors, as well as the ability to choose any weighting, including market cap weights, for each holding; this investing technology, while incredibly complex, is scalable and accessible on the Folio platform.
  • Tax efficiency. Investors can harvest tax losses or gains on individual stocks within the direct index, according to their needs. In this regard, direct indexing allows for a more distinct level of granularity and transparency.
  • Cost efficiency. With direct indexing, investors only pay a fee on the trades they make, which may be beneficial. This savings will be magnified with a custodian (like Folio) that offers a low asset-based fee with commission-free trading.

SRI/ESG Investing and Direct Indexing:  Perfect Together

Because the investor owns the underlying security, direct indexing is perfect for investors who want to restrict certain industries, stocks, or sectors from their own respective accounts. It can work in a few ways. Advisors could create their own models based around sustainable energy. In addition, advisors could leverage a popular large cap index while excluding, for example, firearms and defense companies. Another way to employ direct indexing for SRI/ESG investing is to mirror an existing SRI/ESG index. In other words, direct indexing offers a wide range of possibilities, allowing firms to up their advisor alpha while providing clients with the bespoke SRI/ESG portfolios they increasingly want.

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*Sustainable, responsible, and impact (SRI) investing and environmental, social, and governance (ESG) investing

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