How Robo-Advisors Simplify Impact Investing

Over the past several years, a growing number of investors have shown an interest in putting their money where their values are by investing in companies that meet environmental or social standards. Socially responsible investing (SRI) and environmental, social, and governance (ESG), or impact investing, is especially popular among younger generations.

Increasingly, technology-heavy robo-advisors such as Betterment and Wealthfront are offering portfolios to appeal to SRI investors. Learn more about how a robo-advisor can help with impact investing.

SRI and ESG

Environmental, social, and governance criteria are a set of standards for a company’s operations that socially conscious investors use to screen potential investments. Environmental criteria consider how a company impacts the environment. Social criteria examine how it manages relationships with employees, suppliers, customers, and the communities where it operates. Governance deals with a company’s leadership, executive pay, audits, internal controls, and shareholder rights.

Socially responsible investing is when an investment focuses on the company’s business. Socially responsible investments ignore companies that produce or sell addictive substances (like alcohol, gambling, and tobacco) in favor of seeking out companies that are engaged in social justice, environmental sustainability, and alternative energy/clean technology efforts.

Impact Investing With Robo-Advisors

Robo-advisors automate and optimize portfolio choices and offer low costs and minimal human involvement. Traditionally, robo-advisors follow the logic of modern portfolio theory (MPT) to optimize a diversified portfolio. Indexing, however, implies that every stock in an index be held at its given weight in that index. Therefore, index investors will likely hold shares in companies that are not SRI or ESG-friendly.

To solve this issue, many robo-advisors now seek out exchange-traded funds (ETFs) that specialize in SRI and ESG investments.

The best robo-advisors can improve SRI investing for many individual investors. Some investors buy SRI funds that carry high management fees or sales loads, while robo-advisors seek out low-cost ETFs.

Others investors may screen for SRI stocks in such a way that they forgo the benefits of proper diversification against risk. These investors pick their own basket of SRI stocks, which can be a challenging and time-intensive approach. Robo-advisors can help these investors by automating portfolio rebalancing and engage in tax-loss harvesting to minimize tax exposure for investors.

The Role of Robo-Advisors

Robo-advisors have evolved to accommodate the rise of impact investing primarily by incorporating ESG criteria into their algorithmic portfolio management systems.

Their models are designed to create a diversified portfolio that aligns with your risk tolerance, financial goals, and ethical values. However, by limiting the universe of available securities to those that score highly for SRI/ESG, you may not be able to achieve full-diversification that you would with non SRI/ESG compliant stocks and other assets.

Some robo-advisors use ESG-optimized ETFs, while others allow investors to personalize their portfolios by excluding certain companies. Each robo-advisor approaches SRI and ESG portfolio construction a little bit differently.

Here are some examples of popular robo-advisors:

• Betterment: Betterment seeks out SRI funds for U.S. large-cap stocks and emerging markets stocks only. The stocks, but not bonds, of companies like Exxon Mobile, Chevron, and Philip Morris may be excluded.
• Wealthfront: Wealthfront allows certain users to instead restrict which companies they do not want to invest in with its U.S. Direct Indexing.
• Empower: Empower (formerly Personal Capital) is intended for higher-net-worth individuals, with a minimum opening balance of $100,000 to get started. For those customers, Empower does offer SRI portfolio options. The ESG components only apply to ETFs chosen for U.S. equity components of their portfolios. The rest of the asset class components rely on traditional ETFs and funds.
• Wealthsimple: Wealthsimple takes a more complete approach to SRI investing, utilizing ESG-optimized ETFs for both equities and fixed income components and splitting these up by criteria. For instance, they use one ETF that invests in global stocks while excluding companies focusing on fossil fuels, tobacco, and weapons. On the bonds side, they seek out municipal bonds issued by local or state governments and short-term corporate bonds that have socially-responsible values. Wealthsimple uses their proprietary ETFs.
• Ellevest: Ellevest is the robo-advisor specifically intended for female investors. Ellevest includes funds that support growing small businesses owned by women and other underrepresented populations in its impact portfolios—in addition to more traditional ESG-focused ETFs.

The Bottom Line

The trend of socially responsible investing is indeed likely to influence the future development of robo-advisory platforms. As more investors show interest in aligning their investments with their ethical values, robo-advisors are likely to continue to adapt their algorithms and offer more personalized options to cater to these preferences. They may also incorporate more nuanced or industry-specific ESG criteria, offer more educational resources on impact investing, or even partner with nonprofit organizations or social enterprises to further enhance their social impact.

Consider consulting a financial advisor for more guidance on how a robo-advisor or ESG investing would benefit your investing plan.