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Applying tilts and filters to Direct Indexing can improve ESG scores

Summary

With Direct Indexing (DI), instead of buying an ETF that tracks a stock index, we buy the individual stocks. This makes it easy to customize the portfolio by changing the weights of certain stocks vs. their normal target in their index, or excluding some stocks altogether.

Background

For more general background on DI, including this scenario's parameters, see here.

One reason to deviate from the index is Environmental-Social-Governance (ESG) concerns. For example, a client may want to reduce the weights of stocks whose companies do not have good cybersecurity. Socially Responsible Investing (SRI) is similar, but based more on personal values: e.g. reducing the weights of tobacco and alcohol companies.

Some common terms:

Several companies specialize in creating ESG data. It is not an easy task; e.g. how do you compute a single numeric score for a company's carbon footprint? Our software can read ESG data from any provider - possibly multiple ones at the same time - as long as we do a simple conversion to our common format. This allows us to apply tilts and exclusion filters on any combination of ESG factors across data from different ESG providers.

Test Example Methodology

Results

Our backtests record detailed daily information, including ESG factor exposure. In this case, we are less interested in how the portfolio-wide value of the interesting ESG factor moves over time (x axis). Instead, what is interesting here is that we can validate that using gradually stronger tilts results in holding less of the sinful stocks, just as expected.

The following chart is automatically generated at the end of a set of backtests, so it could also be shown on a live client- or advisor-facing website:

Total 'sinfulness' score at different tilt strengths

Conclusion

Our software can incorporate custom tilts and exclusion filters to improve the ESG aspect of a portfolio, while at the same time combining the other benefits of DI, such as tax-loss harvesting, and our ability to consider held away assets intelligently. Moreover, we can create custom numeric ESG scores and automatically compute and display their values throughout the backtest.