Wall Street has been rushing to satisfy investors’ ravenous appetites for all things ESG for years now.
Hundreds of environmental, social, and governance investment products like mutual funds and exchange-traded funds have hit the market in recent years, as a range of financial data providers—from established players to new sustainable fintech startups—race to develop proprietary ESG ratings. Even Interactive Brokers, the 43-year-old brokerage whose business is entrenched in the active, day-trading community, launched a mobile trading app for “socially conscious” investors on Dec. 8.
It’s a welcome development for investors who have long clamored for more information about the sustainability of companies’ businesses, as well as ways to invest in those that are green. But with a surplus of fund offerings and no standardization from U.S. regulators on companies’ ESG disclosures, the surging levels of product development in the ESG business can ironically make navigating the landscape that much more difficult for both do-it-yourself investors and financial advisers—leaving many asking what to do next.
Enter model portfolios.
On the simplest level, model portfolios tend to be blueprints for how investors can deploy their money and, if all goes to plan, reach their financial goals. And in the burgeoning world of ESG—where there are nearly 700 ETFs in the U.S. alone—that can be an attractive option for financial advisers and investors looking to make sense of where to put their own or their clients’ money.
“Models generally have a lot to offer for investors,” Morningstar’s head of sustainability research, Jon Hale, told Fortune, “and even more so in the sustainable investing space, because investors, particularly advisers, may not have that much experience in selecting ESG funds individually.”
There are a few different ways to think about model portfolios. Some come from robo-advisers like Wealthfront, Betterment, and Acorns, which offer them directly to their individual investor clients. Others are created by the likes of BlackRock to be an off-the-shelf product that financial advisers can use to either complement their own investment management expertise or as a whole portfolio solution for their clients. Assets in these portfolios, sometimes called asset-allocation model portfolios, totaled $1.9 trillion at the end of 2020, according to Cerulli. Then there are model-delivered and manager-traded separately managed accounts, which can be more tailored and customized than the others.
No matter the lens, though, the model portfolio space is growing.
Morningstar has found that the total count of model portfolios reported to its database has more than doubled since 2020 to surpass 2,100, according to a September report.
Usually composed of mutual funds and ETFs, model portfolios have come into vogue for a few reasons. One of the biggest, among financial advisers at least, is the simple fact that models offer a way for them to refocus their time on building wealth for their clients more holistically while also adding new ones. Today, financial advisers often spend a substantial chunk of their days coming up with different investment recommendations.
“We work with thousands of financial advisers, and the one thing that’s consistent is that time is their most precious resource,” said Eve Cout, head of the model portfolio pillar of BlackRock’s U.S. wealth advisory business. “Advisers spend approximately 40% of their time formulating and implementing investment recommendations, and we believe with our research that a models-based practice can cut that time in half.”
The other element is the fact that models provide advisers and investors a more holistic and sometimes customizable way to approach investing, which is an upgrade in the eyes of many from the ad hoc strategy of buying up different funds left and right—especially in the world of ESG.
Of the 2,100 model portfolios reported into Morningstar, the majority—1,382 to be exact—were either based on a target-risk or tax-oriented investment objective. At No. 3, with 114 model portfolios, was ESG. It’s a minuscule sum compared with the broader total, but one that Wall Street figures will grow in the months and years ahead as ESG investing moves even further into the mainstream.
“Investors are watching how companies are treating their employees, communities, [and] customers,” said Sylvia Kwan, chief investment officer at women-focused robo-adviser Ellevest, which has $1 billion in assets under management. “There’s a lot of heightened visibility in terms of how companies are behaving, and I think that’s really driven and accelerating this trend that’s already going more toward impact and sustainable investing.”
Ellevest offers what it calls impact portfolios to its customers, whether they be those investing with no account minimum or the private wealth management customers for whom Ellevest offers a more bespoke portfolio option. (The account minimum of an Ellevest Intentional Impact Portfolio in the company’s private wealth management division is $250,000, according to its website.) The Sallie Krawcheck–led firm first ventured into the model business in 2019 as a way to allow investors to invest “in companies that meet our criteria for doing the right things by women—and redirect your money away from companies with products, policies, and practices that may harm them,” according to a blog post on its website. Then, in 2020, Ellevest widened the scope of its intentional impact portfolios to also look at racial justice issues.
Now new clients of Ellevest are choosing impact investing strategies over core ones at rates of 45% to 50% from when it first began offering them, Kwan says. When the impact investment portfolio launched, it was around 25%.
“We are seeing significant interest across the board for impact investing,” Kwan says.
It’s not just do-it-yourself investors who are using models as a means for ESG exposure, either. In a recent survey conducted by Cerulli, 57% of respondents named “incorporating ESG factors/criteria into models” as one of the most important asset-allocation model product development initiatives in 2021. Last year, it got 36% of the vote. And at BlackRock, the world’s leading model portfolio creator, ESG has grown “tremendously” within the model business, which now counts total assets of $68 billion in the U.S. and $170 billion globally, Cout said.
Sustainable direct indexing
Models used by wealthier investors—sometimes in the form of what is known as direct indexing—may ultimately be the future for ESG, though.
What direct indexing does is give investors and financial advisers the ability to take the holding of an index like the S&P 500, put all of those into a specific type of account, and pull out the ones the investor doesn’t want or add in others they do. And while it may sound like a fancy ETF, direct indexing is distinct in that level of customization—which ESG bulls see as being pivotal to gaining widespread use of such strategies.
The biggest challenge to making direct indexing widely available has been that it’s a pricey endeavor. Account minimums to be able to do so with your investments have come down, but are still well out of reach for many as firms like a direct indexing pioneer Parametric, Wealthfront, and others reserve the services for those clients with at least $100,000 today.
Veriti Management, a Boston direct-indexing firm that has more than $1 billion of assets under management, currently has a $250,000 account minimum, but that’s “probably going down from there,” says Dennis Hammond, head of institutional investments. And that will be key, as Hammond equates the idea of investors relying on ESG funds for their sustainable investing efforts to trying to order a suit online. Direct indexing, on the other hand, is a more bespoke, tailored offering.
“The bottom line is, even if you use the correct category, it’s not going to fit,” Hammond told Fortune. “You want a suit that’s custom made. And that’s the problem with these funds. There are a myriad of ESG issues, everything from fossil fuel to tobacco to private prisons to single-use plastics. And inside each of these, you can drill down to 12 layers. Using a fund is second best at its best.”
This story is part of The Path to Zero, a series of special reports on how business can lead the fight against climate change. This quarter’s report highlights how governments and private industry are approaching the biggest challenges and opportunities in the sustainability space.
