How ESG Strategies in Direct-Indexed Accounts Can Strengthen an Advisor-Client Bond

By Lewis Braham

There are over 50 different options on Parametric’s Responsible Investing Screen Menu for its direct-indexed accounts. Concerned about the selling of opioids by big pharma? Check “Opiod Controversies” and those companies will be left out. Think coal is toxic but shale gas is the bee’s knees? Check “Thermal Coal Reserves” but leave “Shale Oil & Gas Reserves” unchecked and you’ll eliminate the former but not the latter. A devout Catholic, Muslim, Jew, or Baptist? Check any one of those boxes. You’ll see a description of religiously restricted industries.

Direct-indexed accounts are customized private ones for high-net-worth individual investors, in Parametric’s case those with at least $150,000 to invest. Like an indexed mutual or exchange traded fund, they are meant to track a certain benchmark but also to leave out specific securities or industries a client wants and, perhaps, overweight others. For advisers seeking to execute a client’s wishes for a portfolio that adheres to her personal values or specific environmental, social, and governance restrictions, such accounts offer a level of control and engagement impossible to find in public funds.

“In the early days of ESG, especially for mutual funds and ETFs, there was a lot of talk around the definition of ESG, and who was defining it,” says Amrita Nandakumar, president of Vident Investment Advisory, an adviser to $8 billion in both ETFs and direct-indexed accounts. “‘Are you working with the right nonprofit organizations and charities for your index’s definition of ESG?’ The beauty of direct indexing is that you allow the investor to define what ESG means to him or her because I suspect what ESG means to me might mean something different to you.” 

Managing Partner Joe McLean of Intersect Capital, who runs $1.4 billion for primarily professional athletes, calls ESG direct-indexed accounts “the pillar” of his equity strategies:

“I have a large chunk of young investors who socially are very aware of the state of the world and our country at the moment. So, we’ve actually dug even deeper inside ESG and have been designing social justice [direct] indexes on behalf of the clients.” 

McLean has formed a partnership with quant firm O’Shaughnessy Asset Management in an advisory group called Canvas to help execute his account strategies. 

McLean’s screens tilt toward companies with diverse boards, and good human and labor rights records, and away from companies with poor diversity and social justice records such as predatory lenders and for-profit private prisons. Although the minimum to invest in accounts tracking a customized version of McLean’s proprietary Intersect Global Equity Index is $250,000, the fee is only 0.24%, which is competitive with many ESG funds.

Direct indexing in general, and with ESG accounts in particular, can strengthen the advisor-client relationship. “These have been the best conversations that we have ever had with existing clients because technology has finally caught up with the values that a lot of investors always wanted to apply to their portfolios,” McLean says. “They can understand how companies get inside their index [account], and how they get kicked out.”

One drawback to ESG investing is the potential for tracking error against traditional benchmarks from screening out certain stocks or entire industries. Most direct-indexing managers provide an estimate of what the annual tracking error will be based on the past performance of employing specific screens. So, next to each box on Parametric’s ESG menu is an estimated tracking error versus the MSCI ACWI Index, one of the broadest global benchmarks. If you choose Racial Justice, the estimated tracker error is 0.40%, while if you click Opioid Controversies, it’s 0.90%. That tracking error, though, could be on the upside or the down. 

Some clients are OK with more tracking error than others, depending on how serious they are about ESG. “What we do is give [ESG investors] options, and we help educate them and set expectations,” says Jennifer Sireklove, a Parametric investment strategist who helped build its ESG platform. “We have clients for whom [0.5 percentage points annually] is as much tracking error as they want. We have clients who are fine with [1.5 percentage points].” The goal is for them to “make fully informed decisions.” That level of investor understanding generally doesn’t exist in the fund world. 

Shareholder engagement with companies via proposals seeking to change their environmental or other policies has become a big trend in recent years. One significant advantage to private ESG accounts is that if a client chooses, she can have complete control over how her account votes on such proposals. The largest public fund managers have a spotty support record for proposals such as requesting climate risk control or gender pay equity reports. With 2020’s ESG resolutions, for instance, Vanguard and BlackRock supported 24% and 16%, respectively, of ESG proposals overall.

Unfortunately, most direct-account providers only offer an all-or-nothing approach where clients (or their advisers) either receive every proposal for hundreds of stocks or they delegate the voting to the account manager, which may not vote according to the client’s precise values.

Sireklove says Parametric is considering customized voting. “I think it would be the perfect world where you can balance [the voting] out. If you have strong opinions on something, you could voice that, but you’re not on the hook to vote on 10,000 [shareholder proxy vote] meetings.” If that becomes possible, ESG-oriented clients would be engaged on every possible level.