Integrating ESG or Faith-Based Values

What Values-Based Investing Means

Values-based investing modifies portfolio construction to reflect environmental, social, governance (ESG), or faith-based principles. This approach accepts potential performance differences in exchange for alignment between financial holdings and personal beliefs.

ESG investing evaluates companies on non-financial criteria:

• Environmental: Carbon emissions, renewable energy use, waste management
• Social: Labor practices, diversity, supply chain conditions
• Governance: Board independence, executive compensation, shareholder rights

Faith-based investing screens out companies that conflict with religious principles:

• Islamic finance (Shariah-compliant): No interest (riba), no alcohol, no gambling, no pork products
• Christian investing: May exclude alcohol, tobacco, gambling, certain entertainment
• Catholic investing: Often excludes contraception manufacturers, abortion providers

The global sustainable investment market reached $35.3 trillion in assets under management in 2020 (Global Sustainable Investment Alliance), representing 36% of all professionally managed assets in major markets.

Screening Approaches

Negative Screening (Exclusion)

Removes companies or sectors that violate specified criteria.

Common exclusions:

Impact on portfolio:

• S&P 500 exclusion of fossil fuels removes approximately 4% of index weight
• Tobacco exclusion removes approximately 1.5% of index weight
• Multiple exclusions combined may remove 10-20% of investable universe

Positive Screening (Best-in-Class)

Selects companies with strongest ESG ratings within each sector rather than excluding entire sectors.

Example approach:

• Include oil companies but only those with highest environmental ratings
• Include all sectors but weight toward top ESG performers
• Result: More diversified portfolio than exclusionary approach

Rating sources:

• MSCI ESG Ratings: AAA to CCC scale
• Sustainalytics: Risk ratings (negligible to severe)
• S&P Global ESG Scores: 0-100 scale
• CDP: Climate disclosure grades (A to F)

Impact Investing

Targets companies explicitly attempting to solve social or environmental problems.

Themes:

• Clean energy producers and technology companies
• Affordable housing developers
• Healthcare access in underserved areas
• Sustainable agriculture and food systems

Tradeoff: Narrower investment universe creates higher concentration risk.

Available Fund Options

Broad ESG Index Funds

Vanguard ESG U.S. Stock ETF (ESGV)

• Expense ratio: 0.09%
• Excludes: Weapons, tobacco, fossil fuels, gambling, adult entertainment, nuclear power
• Holdings: Approximately 1,500 stocks
• 5-year return through 2023: 14.2% annualized

iShares ESG Aware MSCI USA ETF (ESGU)

• Expense ratio: 0.15%
• Approach: Best-in-class ESG scoring, minimal exclusions
• Holdings: Approximately 320 stocks
• 5-year return through 2023: 14.8% annualized

Parnassus Core Equity Fund (PRBLX)

• Expense ratio: 0.82%
• Active management with ESG integration
• Holdings: Approximately 40 stocks
• 5-year return through 2023: 13.1% annualized

Fossil-Fuel-Free Options

SPDR S&P 500 Fossil Fuel Reserves Free ETF (SPYX)

• Expense ratio: 0.20%
• Tracks S&P 500 excluding companies owning fossil fuel reserves
• Excludes approximately 30 companies from S&P 500
• 5-year return through 2023: 15.1% annualized

iShares MSCI ACWI Low Carbon Target ETF (CRBN)

• Expense ratio: 0.20%
• Global exposure with reduced carbon intensity
• Targets 50% reduction in carbon emissions versus benchmark

Faith-Based Funds

Ave Maria Mutual Funds (Catholic)

• Ave Maria Rising Dividend Fund (AVEDX): 0.91% expense ratio
• Screens: No abortion, contraception, pornography
• 5-year return through 2023: 11.8% annualized

Eventide Gilead Fund (ETGLX)

• Expense ratio: 1.03%
• Christian values screening with focus on companies "creating value for others"
• 5-year return through 2023: 8.2% annualized

Azzad Ethical Fund (ADJEX)

• Expense ratio: 1.25%
• Shariah-compliant (Islamic finance principles)
• No interest income, no prohibited industries
• 5-year return through 2023: 10.9% annualized

Amana Income Fund (AMANX)

• Expense ratio: 1.03%
• Shariah-compliant dividend focus
• 5-year return through 2023: 9.4% annualized

Bond Funds

iShares ESG Aware U.S. Aggregate Bond ETF (EAGG)

• Expense ratio: 0.10%
• ESG-screened investment-grade bonds
• Yield: Comparable to AGG (4.2% as of late 2023)

Parnassus Fixed Income Fund (PRFIX)

• Expense ratio: 0.68%
• Active ESG bond management
• Excludes weapons, tobacco, fossil fuels

Performance Considerations

Historical Return Comparison

Performance data through December 2023 (5-year annualized):

Observations:

• Broad ESG funds tracked within 1-2 percentage points of benchmark
• Fossil-fuel-free funds slightly outperformed during 2020-2023 (energy sector underperformance)
• Faith-based funds with higher expense ratios showed larger performance gaps
• Individual year results vary significantly (energy outperformed in 2021-2022)

Tracking Error and Sector Differences

ESG funds deviate from benchmark due to exclusions and weighting differences:

Typical ESG fund underweights:

• Energy sector: 50-100% underweight versus benchmark
• Materials: 20-40% underweight
• Utilities: Variable (depends on renewable energy holdings)

Typical ESG fund overweights:

• Technology: 10-30% overweight
• Healthcare: 5-15% overweight
• Consumer discretionary: 5-10% overweight

Performance implication: When energy outperforms (2021-2022), ESG funds underperform benchmark. When technology outperforms (2020, 2023), ESG funds may outperform benchmark.

Cost of Values Alignment

Expense ratio difference:

• Broad market index fund: 0.03% (e.g., VTI)
• ESG index fund: 0.09-0.15%
• Faith-based actively managed fund: 0.80-1.25%

Annual cost on $100,000 portfolio:

• VTI (0.03%): $30/year
• ESGV (0.09%): $90/year
• Ave Maria fund (0.91%): $910/year

20-year impact of 0.88% higher expense ratio: Starting $100,000 at 8% gross return:

• At 0.03% expense: $457,620
• At 0.91% expense: $380,613
• Difference: $77,007 (17% less wealth)

Worked Example: Building an ESG Portfolio

Investor profile:

• Age 40, 25-year time horizon
• Current portfolio: $250,000 (100% in VTI)
• Goal: Align with environmental values while maintaining broad diversification
• Priorities: Exclude fossil fuels, prefer companies with strong governance

Option 1: Single ESG fund replacement

• Sell VTI ($250,000)
• Buy ESGV ($250,000)
• Result: Immediate values alignment, 0.06% higher expense ratio ($150/year)
• Tracking difference versus VTI: Approximately 1-2% annually

Option 2: Core and satellite approach

• Core (80%): ESGV at $200,000
• Satellite (20%): ICLN (iShares Global Clean Energy ETF) at $50,000
• Result: Broad ESG exposure with clean energy tilt
• Expense ratio: 0.09% on core, 0.40% on satellite = blended 0.15%
• Higher concentration risk in clean energy

Option 3: Multi-asset ESG portfolio

• U.S. equity (50%): ESGV at $125,000
• International equity (20%): ESGD (iShares ESG Aware MSCI EAFE) at $50,000
• Bonds (30%): EAGG at $75,000
• Blended expense ratio: 0.11%
• Full asset class diversification with values alignment

Tax consideration: Selling $250,000 of VTI with $50,000 unrealized gains triggers approximately $7,500 in capital gains taxes (15% rate). Consider:

• Gradual transition over 3-5 years
• Transition in tax-advantaged accounts first (no tax impact)
• Tax-loss harvesting opportunities to offset gains

Implementation Considerations

Define Your Priorities

Not all values-based approaches align with all values. Clarify priorities:

Questions to answer:

1. Which issues are absolute exclusions (will not invest regardless of company performance)?
2. Which issues allow best-in-class approach (will invest in sector leaders)?
3. Are you willing to accept lower diversification for stricter screening?
4. What expense ratio premium is acceptable for values alignment?

Research Fund Screening Criteria

ESG ratings lack standardization. The same company may receive high marks from one rating agency and low marks from another.

Due diligence steps:

• Read fund prospectus for specific exclusion criteria
• Review top 10 holdings for any unexpected inclusions
• Check if fund holds companies you consider misaligned with your values
• Understand whether fund uses exclusion, best-in-class, or impact approach

Example discrepancy: Some ESG funds hold Amazon (labor practice concerns) and Meta (data privacy concerns). If these issues matter to you, verify fund holdings before investing.

Balance Values and Diversification

Stricter screening reduces investable universe and increases concentration risk.

Diversification guidelines:

• Broad ESG funds (1,000+ holdings): Minimal diversification sacrifice
• Thematic funds (50-100 holdings): Meaningful concentration risk
• Single-sector impact funds (clean energy, water): Significant concentration risk

Recommendation: Use broad ESG funds for core portfolio; limit thematic or sector funds to 10-20% of portfolio.

Values-Based Investing Checklist

• Define which values are absolute exclusions versus best-in-class preferences
• Compare expense ratios between values-aligned funds and broad market alternatives
• Review top holdings of selected funds to verify alignment with stated values
• Calculate performance difference versus benchmark over 5+ year period (accept or seek alternatives)
• Assess tax implications of transitioning existing holdings to values-based funds
• Maintain diversification across asset classes even with values screens applied

Next Steps

Start by reviewing your current portfolio holdings for alignment with your values. Many investors discover their index funds hold companies they would prefer not to own. Tools like Fossil Free Funds (fossilfreefunds.org) or As You Sow (asyousow.org/invest-your-values) provide free screening of mutual funds and ETFs.

If transitioning an existing portfolio, prioritize changes in tax-advantaged accounts (IRA, 401(k)) where sales do not trigger capital gains taxes. For taxable accounts, consider gradual transition over 3-5 years to spread tax impact and potentially harvest losses to offset gains.

Recognize that values-based investing involves tradeoffs. Perfect alignment with all values may not exist in any single fund. Prioritize your most important screens and accept that some compromises may be necessary for portfolio construction.