October 18, 2022 | Vanguard Perspective
Offer clients custom ESG options with direct indexing
Your clients want to make sure their investments reflect the issues they care about and avoid supporting others. Their desire has made environmental, social, and governance (ESG) investing, also known as socially responsible, faith-based, values-driven, or sustainable investing, a burgeoning trend.1
It's true that you can help align clients' investments with their preferences using off-the-shelf ETFs and mutual funds. But for clients with very specific ideas about causes or issues they want their investments to support or exclude, Vanguard Personalized Indexing could be a more precise solution.
Get more than "E" for environmental
Like many people, your clients may focus mostly on the "E" of ESG—that is, environmental concerns like a company's carbon footprint or involvement with fossil fuels—but ESG investing can cover a much wider range of issues. For example, your clients can:
- Incorporate religious preferences into their portfolios.
- Avoid investing in companies involved in activities they find objectionable, such as predatory lending or gambling.
- Support companies that pay their workers a fair living wage or that advance diversity on the board of directors.
- Choose multiple issues to tailor the portfolio's focus to suit their preferences. A client could focus on specific social issues as well as climate change, for example.
What makes a direct indexing portfolio so flexible? It's all in the structure—and its easy-to-use technology. With mutual funds or ETFs, investors own a single fund that bundles individual stocks together. With a Vanguard Personalized Indexing portfolio, investors own individual stocks directly in separately managed accounts (SMAs). The stocks in each SMA represent a benchmark that you and your client select. Direct ownership of each stock makes an SMA fully customizable—you can build portfolios that precisely reflect each client's preferences and outlook.
Customize SMAs with screens and tilts
You can use negative screens, positive tilts, or a combination of both to tailor your clients' portfolios with direct indexing.
- A screen eliminates certain companies, sectors, or industries from a client's portfolio entirely, according to criteria each client selects. For example, your client might want to avoid any investment with companies that produce adult entertainment or nuclear weapons, or that violate their religious principles. You can even screen out a single company if a client has strong feelings against investing in it.
Use screens in cases where you need to ensure that all companies that violate a client's principles are excluded from the portfolio.
- Tilts add a preferential weight to a portfolio that helps improve its focus on topics that are important to a client. In contrast to the black-and-white exclusion of screens, you can use tilts to help clients support issues that fall within a gradient. Examples include weighting a portfolio with companies that are moving toward a lower carbon footprint or are increasing the number of women in leadership roles.
Think of it this way: Tilts let clients express support of companies that engage in "good" behavior on an issue, whereas screens let them express disapproval of "bad" behavior by a company.2
Vanguard Personalized Indexing offers a wide range of screens and tilts for your clients to choose from. You can also request custom options, such as faith-based or vegan. Once your clients have made their selections, you can generate impact and performance reports on demand, so clients can have a clear picture of the impact of their customizations.
Keep an eye on customization and risk levels
Vanguard Personalized Indexing is a flexible, transparent way to customize a client’s portfolio, but sometimes customizations can require special consideration from you.
- Tracking error: You can apply as many customizations to clients' direct indexing portfolios as they wish. However, each customization can potentially increase tracking error from the portfolio's underlying benchmark, increasing a client's risk.
- Limited market exposure: A client who wants to screen out all companies that have engaged in controversial activities could be left with very few companies to invest in, potentially limiting their exposure to the market and reducing their portfolio’s diversification benefits.
- Contradictory tilts: When too many tilts are chosen, they tend to cancel each other out, diluting the client's desired impact.
In these cases, you can help your clients understand that positive impact doesn't require perfection. Together, you and your clients can prioritize their goals. That way, you can ensure that each direct index is customized effectively and that clients are comfortable with the risk level in their portfolios.
Deepen client relationships
Vanguard Personalized Indexing gives you the power to offer clients a highly personalized, index-based, tax-efficient solution that incorporates their unique preferences. It can also give you an opportunity to forge deeper emotional connections with your clients as you discuss their varying interests and experiences and how they might want to incorporate them into their investments.
1 Alyssa Stankiewicz, 2022. Sustainable Fund Flows Dip for the Quarter but Peak for the Year, Morningstar.com. (Sustainability Matters.) Accessed July 22, 2022, at https://www.morningstar.com/articles/1076648/sustainable-fund-flows-dip-for-the-quarter-but-peak-for-the-year.
2 "Good" and "bad" behaviors are based on the data provider's criteria and may vary from an investor's personal beliefs and values.
- Vanguard Personalized Indexing Management, LLC ("Vanguard Personalized Indexing Management"), formerly Just Invest, LLC, an SEC-registered investment advisor, is an independently operated wholly-owned subsidiary of The Vanguard Group, Inc. ("Vanguard"). Vanguard Personalized Indexing is an asset management technology that has been developed and is offered solely by Vanguard Personalized Indexing Management.
- All investing is subject to risk, including possible loss of principal. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss.
- ESG portfolios are subject to ESG investment risk, which is the chance that the stocks or bonds screened by the data provider for ESG criteria generally will underperform the market as a whole or, in the aggregate, will trail returns of other portfolios screened for ESG criteria. The data provider's assessment of a company, based on the company's level of involvement in a particular industry or the data provider's own ESG criteria, may differ from that of other portfolios or of the advisor's or an investor's assessment of such company. As a result, the companies deemed eligible by the data provider may not reflect the beliefs and values of any particular investor and certain screens may not exhibit positive or favorable ESG characteristics. The evaluation of companies for ESG screening or integration is dependent on the timely and accurate reporting of ESG data by the companies. Successful application of the customized investment strategy will depend on the data provider's proper identification and analysis of ESG data.
- For more information on Vanguard Personalized Indexing Management and Vanguard Personalized Indexing, and to access Vanguard Personalized Indexing Management's Form CRS and Form ADV Part 2A disclosure brochure, please visit the Vanguard Personalized Indexing topic page.