Insights

How to Build an ESG Core When Harvesting Losses

When I talk to clients about tax-loss harvesting, discussions have recently centered on using Environmental, Social, Governance (ESG) strategies as replacements for the traditional core exposures — e.g., US large caps, international-developed, bonds — they plan to sell at a loss.

Widespread market losses and the increased availability of ESG funds make harvesting losses and repositioning for ESG a compelling proposition now.

This is especially true when you consider that in 1994, the last calendar year both the S&P 500 Index and the Bloomberg US Aggregate Bond Index posted negative returns,1 there was only one single solitary exchange traded fund available.

Now, investors can choose from more than 2,000 ETFs that span a wide array of strategy types and disciplines, including an increasing number of ESG-focused funds.


Head of SPDR Americas Research

Integrating ESG Using SPDR ETFs

After harvesting losses in traditional core assets, SPDR® ESG ETFs can help you implement an ESG strategy with a broad market focus.

Below are specific SPDR ESG ETF replacements to consider.

SPDR ESG ETF Replacements for Traditional Markets

Traditional Market of Focus Potential ESG Option
Equities
US Large Cap SPDR S&P 500 ESG ETF (EFIV)
US Small Cap SPDR S&P SmallCap 600 ESG ETF (ESIX)
Non-US Developed SPDR Bloomberg SASB Developed Markets EX US ESG Select (RDMX)
Emerging Market SPDR Bloomberg SASB Emerging Markets ESG Select ETF (REMG)
Bonds
US Treasuries No ESG ETF Available
US Corporates SPDR Bloomberg SASB Corporate Bond ESG Select ETF (RBND)
US Mortgage-Backed Securities No ESG ETF Available

Source: SPDR Americas Research as of 8/4/2022.

But before you build an ESG core, you’ll want to consider the following:

  • An ESG strategy that is broadly diversified with high representation of securities in the market of focus is likely preferrable to a concentrated, more thematic allocation.
  • If the ESG strategy uses a different parent benchmark than the harvested position, a beneath-the-surface analytical review is critical.
  • For some sub-sectors, like US Treasuries, an ESG version of the traditional market exposure is not available. In that case, you may still want to harvest the traditional position and replace it with a lower cost ETF with the same market focus.

With these caveats in mind, let’s look at how you can construct an ESG core portfolio with a profile similar to a traditional allocation.

How to Build an ESG Core

It is possible to build an ESG core portfolio with a profile similar to a traditional one. To learn how, take a look at the example below, which represents a traditional 60/40 portfolio composed of stocks and bonds, and weights of US versus Non-US stocks, within a global benchmark.2

This example uses traditional funds for Treasuries and mortgage-backed securities within the fixed income allocation, since there are currently no ESG ETFs that offer exposure to those markets.

Potential ETF Weight (%)
Equities
SPDR S&P 500 ESG ETF (EFIV) 33.6%
SPDR S&P SmallCap 600 ESG ETF (ESIX) 3.6%
SPDR Bloomberg SASB Developed Markets EX US ESG Select (RDMX) 15.6%
SPDR Bloomberg SASB Emerging Markets ESG Select ETF (REMG) 7.2%
Bonds
SPDR Portfolio Intermediate Term Treasury ETF (SPTI) 16.0%
SPDR Bloomberg SASB Corporate Bond ESG Select ETF (RBND) 10.0%
SPDR Portfolio Mortgage Backed Bond ETF (SPMB) 14.0%

Source: SPDR Americas Research as of 8/4/2022. Weights are as of the date indicated, are subject to change, and should not be relied upon as current thereafter.

Comparing ESG Core to Traditional Allocation

The ESG ETFs in the above example are broadly diversified with fair representation of the underlying markets (some are optimized with tracking error constraints to traditional beta versions).

As a result, the equity sector ESG portfolio doesn’t differ much from the traditional market cap weighted portfolio — less than 2% actually. Tech is the largest overweight and Consumer Discretionary is the largest underweight, as shown below.

Equity Sector Weight Differences of ESG vs. Traditional Portfolio

Equity Sector Weight Differences of ESG vs. Traditional Portfolio

From a country perspective, the largest overweight is France (0.58%) and the largest underweight is Japan (-0.52%).3 This is a byproduct of selecting regional weights (US versus rest of world) based on current traditional market cap weights.

But, because the underlying ETF strategies do not weight based on market cap alone, there could be a difference in the market cap segment. However, the average market cap of this ESG portfolio is similar to broad beta. Other traditional fundamental metrics are in line as well, as shown below.

Equity Fundamental Differences Between ESG and Traditional Portfolios

  ESG Portfolio Traditional Market Difference
Price to Book Ratio 2.46 2.38 0.08
Price to Earnings Ratio 15.18 15.35 -0.17
Price to Sales Ratio 1.64 1.63 0.01
Enterprise Value-to-Sales Ratio 2.01 1.99 0.02
Total Debt to Total Capital (%) 45.16 44.21 0.96
Return on Equity (%) 36.96 32.98 3.98
Market Capitalization ($ Billion) 438.8 357.4 81.4

Source: SPDR Americas Research as of 8/4/2022 based on data from Bloomberg Finance L.P.. Traditional allocations defined by US Large Cap = S&P 500 Index, US Small Cap = S&P Small Cap 600 Index, Non-US Developed Markets = S&P Developed Ex-US BMI Index, Emerging Markets = S&P Emerging Markets Index. Characteristics are as of the date indicated, are subject to change, and should not be relied upon as current thereafter.

Since only one allocation was changed in the fixed income portion of the ESG portfolio, its yield, duration, and credit spread (2.83%, 5.9 years, and 45 basis points) are similar to the traditional core (2.86%, 5.9 years, and 49 basis points).4

A Risk-based View of the Two Portfolios

Using the Bloomberg Global Multi-Asset Risk Model to show ex-ante active risk and beta, the ESG core portfolio takes on a lower amount of active risk (68 basis points) and the beta is 0.99.

Active Risk Analysis of ESG Core Portfolio

  Total Risk (%)
ESG Portfolio 12.13
Traditional Market 12.28
Active Risk 0.68

Source: SPDR Americas Research as of 8/4/2022 based on data from Bloomberg Finance L.P.. Traditional allocations defined by US Large Cap = S&P 500 Index, US Small Cap = S&P Small Cap 600 Index, Non-US Developed Markets = S&P Developed Ex-US BMI Index, Emerging Markets = S&P Emerging Markets Index. Characteristics are as of the date indicated, are subject to change, and should not be relied upon as current thereafter.

Drivers of active risk in the ESG portfolio are explained by stock-specific factors — an intuitive trend given that stocks are weighted differently and some are excluded entirely — as well as certain equity style factors, as shown below. And within style, a positive loading towards firms with stronger profitability profiles represents the largest style contributor to active risk.

Contributors to Total Active Risk (%) of ESG Core Portfolio

Contributors to Total Active Risk (%) of ESG Core Portfolio

Harvesting Losses in Core Assets? Consider ESG

Ongoing market volatility across equity and fixed income markets presents big tax-loss harvesting opportunities. In addition to replacing out higher-fee mutual funds for lower-cost ETFs, you can use tax replacements to refine exposures, target new ESG strategies, and build an ESG core with a similar profile to a more traditional allocation. And the best time to do that may be when the losses in core equity and bond assets are so abundant.

For more investment ideas, check out these SPDR Insights.


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