Model Portfolio Masterclass Series

Episode 11

Model Portfolios for the Modern Investor: Sustainable Investing, From Paris Aligned ETFs and Green Bond ETFs

Building a Sustainable Model Portfolio: Principles and Key Trends

Investment Manager - Irene Bauer
Irene Bauer
Algo-Chain, Co-Founder

Introduction: Understanding Sustainable ETFs and Their Growth

Sustainable investing has its roots in socially responsible investing (SRI) and over the past two decades sustainable investing has evolved into a more sophisticated framework that integrates ESG (Environmental, Social, and Governance) factors to assess investment risks and opportunities. ESG investing has undergone a profound evolution, transitioning from a specialized, value-driven approach to a critical pillar of contemporary financial strategy. Initially conceptualized as a framework for assessing corporate ethicality through distinct environmental, social, and governance criteria, ESG investing has since expanded into a multifaceted discipline that integrates sustainability considerations into asset allocation and risk management.

The lexicon of ESG has likewise broadened, with "sustainable investing" now serving as an overarching construct encompassing ESG integration, socially responsible investing (SRI), and impact investing. This conceptual expansion signifies a paradigm shift in investment philosophy - one that reconciles fiduciary duty with long-term value creation by accounting for systemic sustainability risks and opportunities. Institutional efforts, particularly those led by the CFA Institute and the Principles for Responsible Investment (PRI), have further facilitated the standardization of ESG methodologies, enhancing their analytical rigor and applicability within global financial markets.

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Nevertheless, the ESG investment domain has recently encountered formidable headwinds. In the United States, escalating political resistance has manifested in regulatory scrutiny and legislative initiatives aimed at curtailing the influence of ESG-aligned asset management. Critics argue that ESG integration compromises fiduciary neutrality, prompting legal challenges and policy interventions that have reshaped the regulatory landscape. Concurrently, concerns regarding "greenwashing" – whereby firms overstate or misrepresent their commitment to sustainability – have precipitated a crisis of confidence among investors, exacerbating scepticism regarding ESG’s credibility and efficacy.

Furthermore, performance-related critiques have emerged, as certain ESG-themed funds have exhibited suboptimal returns relative to conventional benchmarks over certain periods of time, calling into question the financial merits of sustainability-oriented strategies. Despite these challenges, ESG investing remains a dynamic and evolving field, characterized by ongoing discourse on its theoretical underpinnings, methodological robustness, and potential for reconciling ethical imperatives with financial performance.

At Algo-Chain we have been strong advocates for sustainable investing, but we have come to accept some of the criticism alluded to above. To gain a better understanding of how this story unfolded, let’s look at the different categories of ESG ETFs and then focus on some of the landmark ETFs that have been launched over the last 20 years.

Choosing the Right ESG ETFs: What to Look For

Implementing a sustainability-focused portfolio via ETFs has several advantages. Firstly, there are a range of different types of exposures available, from general ESG criteria to thematic exposures like clean water or battery technology. Second, ETFs are usually very transparent in their holdings, and, for passive index trackers, also in the way securities are selected.

For wealth managers and advisors constructing ETF model portfolios, integrating ESG principles can provide a pathway to aligning client values with investment performance.

The growing number of ESG-focused ETFs requires careful selection based on investment methodology, performance, and impact metrics; ETFs generally fall into the following categories:
ESG Exclusions: These ETFs exclude companies involved in industries such as fossil fuels, tobacco, and weapons. The remaining holdings typically resemble standard market indexes but exclude controversial sectors.
Classic ESG/Best-in-Class ESG: These ETFs invest in the top-rated ESG companies within each industry, usually selecting the top 25% to 50% based on ESG scores while sometimes incorporating additional exclusion criteria.
ESG Lite/ ESG Enhanced: These ETFs adjust company weightings based on ESG scores rather than fully excluding companies. This allows for broader diversification while still encouraging positive ESG practices, but had also led to some accusations of greenwashing, as all companies are still within the ETF, except for some potential exclusions.
Thematic ESG: These ETFs focus on specific sustainability themes, such as clean energy, gender diversity, or water conservation; there might be some additional exclusion criteria.
Impact Investing: These ETFs target investments in projects or companies with measurable social or environmental benefits, even if the companies themselves do not rank highly on traditional ESG criteria.
Climate-Aligned Strategies: These ETFs aim to reduce carbon emissions, often following Paris-Aligned Benchmarks (PAB) or Climate-Transition Benchmarks (CTB). PAB strategies target a 50% reduction in carbon intensity compared to the broader market, while CTB strategies target a 30% reduction.
ESG Themed ETFs: High Level Classification

Calculating the ESG ratings and rankings according to certain criteria requires a large data set. When investing into ESG related topics via ETFs, the ETF providers will do the hard work of requiring the data and selecting the right companies within an ETF – either themselves or via an index or data provider.

There are several companies available that provide ESG scoring data and strategies for the above-mentioned categories such as MSCI, Sustainalytics, and Morningstar. In addition, the UN has come up with their 17 Sustainable Development Goals (SDGs) and there are some ETF issuers that provide ETFs on several of those UN SDGs. And while ETF providers are gathering or outsourcing all the ESG data for us, the task for a Sustainable model portfolio provider is to understand the differences and nuances between different index providers (or the investment mandates of active ETFs), to provide model portfolios in line with their investment mandates.

How to Build a Sustainable Model Portfolio Using ETFs

There are several steps involved to building a sustainable model portfolio.

Defining Your ESG Investment Goals

Before selecting ETFs, investors must determine their sustainability priorities. Some may aim to reduce carbon footprints, while others may seek to invest in companies that promote social equality or environmental preservation. Clearly defining these objectives ensures alignment with both financial and ethical goals.

Implementing a Core-Satellite Strategy

A well-structured ESG portfolio often follows a core-satellite approach:

  • The core portfolio consists of broad, diversified ESG ETFs, such as Best-in-Class or Climate-Aligned funds, covering equities, fixed income, and alternative assets.
  • The satellite portfolio includes thematic and impact-focused ETFs targeting specific sustainability sectors such as renewable energy, electric vehicles or carbon capture technology.

Managing Risk and Diversification

Just like traditional portfolios, ESG model portfolios should maintain diversification across asset classes, industries, and geographic regions to mitigate concentration risk. While ESG investing has long-term growth potential, certain themes, such as clean energy, may exhibit higher volatility. Portfolio managers should carefully balance these risks while maintaining exposure to high-quality ESG investments.

To measure portfolio risk, investors can analyse historical data from traditional benchmarks as a reference. However, ESG ETFs should be evaluated independently, as their risk-return profiles may differ from conventional investments due to their focus on sustainability factors.

Exploring Thematic ESG ETF Opportunities

For the core part of the portfolio, one can use a range of Classic ESG or climate aligned funds. Let’s focus specifically on some of the ESG-related thematic ETFs from what is a much wider selection available in the markets.

L&G Clean Water UCITS ETF (GLGG LN)

This ETF offers investors exposure to the global clean water industry by tracking the Solactive Clean Water Index. The index comprises companies actively engaged in the clean water sector through technological, digital, engineering, utility, and other services such as water treatment, filtration, infrastructure, and technology. The ETF's sector allocation is predominantly in Industrials (57.16%), followed by Utilities (22.19%) and Technology (10.30%).

Top 5 Holdings**

  • Core & Main (Industrials, 2.56%) – Specializes in the distribution of waterworks and plumbing products.
  • Trimble (Technology, 2.52%) – Uses data analytics for various industries such as construction, agriculture, transportation and geospatial.
  • Mueller Water Products (Industrials, 2.50%) – Operates primarily in the water utility sector, providing solutions for the management and distribution of water.
  • Kadant (Industrials, 2.43%) – Focuses on sustainable filtration and industrial systems.
  • Metso Outotec Oyj (Industrials, 2.36%) – Specializes in sustainable technology and services for the mining, aggregates, and recycling industries.

Investing in the clean water sector aligns with the increasing global emphasis on sustainable and responsible resource management. And with a growing population worldwide comes an increasing need for access to clean water, both for individuals and corporates.

Amundi MSCI Robotics & AI ESG Screened UCITS ETF Acc (GOAI FP)

This ETF provides investors with exposure to companies worldwide that are actively engaged in the development and application of robotics and artificial intelligence (AI) technologies, while adhering to ESG criteria. It tracks the MSCI ACWI IMI Robotics & AI ESG Filtered Index, which includes firms from both developed and emerging markets involved in robotics and AI, filtered according to ESG standards. The index excludes ESG controversial companies like tobacco, oil and gas etc. With the remaining companies it aims to reduce the weighted average greenhouse gas intensity by 50% compared to the broad based Robotics & AI index while also targeting the top 25% of companies of each Global Industry Classification Standard (GICS) sub-sector by ESG score.

The ETF’s sector allocation is predominantly in Technology (63.01%), followed by Industrials (10.91%) and Healthcare (10.87%).

Top 5 Holdings**

  • Intuitive Surgical (Healthcare, 4.66%) – Specializes in robotic-assisted surgical technology.
  • Apple (Information Technology, 4.65%) – Develops AI-powered consumer technology.
  • Alphabet Class C (Communication Services, 4.25%) – Invests in AI research and innovation.
  • Stryker Corporation (Healthcare, 4.23%) – Focuses on medical robotics and innovation, including orthopaedic implants, surgical equipment, and medical instruments.
  • Cisco Systems (Information Technology, 4.16%) – Develops AI-driven network security solutions.

This ETF offers exposure to the rapidly evolving fields of automation and AI, sectors poised for significant growth as technological advancements continue to accelerate. The integration of ESG screening adds an additional layer of ethical consideration, appealing to socially conscious investors.

The ETF highlights that there is more to an ETF than its name. Once one has decided to invest in AI and automation, the real task begins to decide which ETF to choose. Should it be ESG related or not? What is the exact index methodology of the ETF in question? If we stick to this ETF, then the similar, but non ESG related index, the MSCI ACWI IMI Robotics & AI Index, will have a different breakdown of sectors and countries. Looking at the top 5 holding for the non-ESG index, they comprise of Meta, Broadcom, Amazon, Apple and Netflix. All but Apple have not made the ESG scoring cut for the index with ESG filtering, thus quite a different exposure.

One might ask, do the two concepts of automation & AI and ESG go together? It depends on what one is interested in, but this ETF shows that it can work.

iShares $ Development Bank Bonds UCITS ETF Acc (DDBB LN)

This ETF invests in USD-denominated bonds issued by multilateral development banks (MDBs) that finance economic and social projects worldwide. It seeks to replicate the performance of the FTSE World Broad Investment-Grade USD Multilateral Development Bank Bond Capped Index, which includes bonds from MDBs with all G7 countries as members, ensuring a diversified and high-quality bond portfolio.

This ETF, as with most Fixed Income investments, typically holds several bonds of the same issuer, but with different coupon payments and maturity dates.

Top 5 Issuers**

  • Inter-American Development Bank (25.12%)
  • International Bank for Reconstruction and Development (24.63%)
  • Asian Development Bank (24.58%)
  • International Development Association (8.75%)
  • African Development Bank (7.69%)

The fund's significant exposure to the United States reflects the domicile of many MDBs' bond issuances, while the remaining allocation spans various countries, contributing to geographical diversification. Investing in development bank bonds provides exposure to high-quality bonds issued by reputable international institutions dedicated to global development. The fund's focus on USD-denominated bonds from MDBs with G7 membership ensures a blend of creditworthiness and developmental impact with a range of maturity dates and an average weighted maturity of 3.9 years.

In some ways this investment could be seen as very similar to global government bonds. But development bank bonds usually have a lower risk, and this specific ETF also has a lower average weighted maturity than a general global government bond (for example the iShares Global Government Bond UCITS ETF, which has an average weighted maturity of 8.9 years).

Conclusion

Sustainable investing through ETFs is becoming an integral part of modern portfolio management, offering investors the opportunity to align their financial goals with broader environmental, social, and governance (ESG) considerations. By carefully selecting high-quality ESG ETFs, applying a core-satellite strategy, and ensuring proper diversification, investors can build resilient portfolios that not only seek competitive returns but also contribute to positive societal and environmental outcomes.

As ESG investing continues to evolve, staying informed about regulatory developments, new ESG product offerings, and advancements in ESG data and scoring methodologies will be crucial. The increasing scrutiny on greenwashing and the push for greater transparency mean that due diligence in fund selection will become even more important. Furthermore, integrating ESG factors into risk management can enhance long-term portfolio stability by mitigating exposure to companies facing sustainability-related challenges.

Ultimately, as sustainability considerations become a permanent fixture in global financial markets, investors who proactively adapt their approach will be well-positioned to build effective, future-proof portfolios that align with both their financial ambitions and broader ethical values.

Disclaimer

*The podcast provided by Allan Lane & Irene Bauer has been converted from their own original content, into a podcast using Generative AI tools and the voices used in the podcast are not their own. All information provided has been fact checked.

**These weights are correct at the time of writing (28 Feb 2025) are subject to change as the index provides re-balances.

The investments referred to in this podcast is targeted at professional Wealth Managers & Financial Advisors and may not be suitable for all investors. Twenty20 Solutions Ltd does not provide, and nothing in this podcast should be construed as, investment or other advice. It is not intended that anything stated in this podcast should be construed as an offer, or invitation to treat, or inducement for you to engage in any investment activity. The information in this podcast relating to model portfolios & individual funds suggested by Algo-Chain is purely for research and educational purposes only.