Best ESG ETF in Canada

Which is the best ESG ETF in Canada? This post describes how to create a low cost ESG index portfolio that aligns with your values. We will consider which Canadian ETF is the best to use and also highlight alternative ways to construct your own customized ESG portfolio.

We will begin by describing what ESG investing means and what an index fund is.

What is ESG?

ESG stands for Environmental, Social, and Governance. Its a framework that’s used to evaluate the sustainability and ethical impact of a company or investment.

The “E” in ESG refers to the environmental impact of a company’s operations and products, such as its carbon footprint, energy usage, and waste management. The “S” in ESG refers to a company’s social impact, including its labour practices, human rights record, community engagement, and impact on society. The “G” in ESG refers to a company’s governance structure, including its leadership, board composition, executive pay, and shareholder rights.

Investors and analysts use ESG criteria to assess the overall sustainability and ethical impact of companies and investments, in addition to traditional financial metrics. This approach considers not just short-term financial performance but also the long-term impact of a company’s operations and products on the environment, society, and governance. ESG has become an important consideration for investors looking to build sustainable and socially responsible investment portfolios.

What is index investing?

Index investing is a index investment strategy that seeks to track the performance of a specific market index, such as the S&P 500, Dow Jones Industrial Average, or the Nasdaq Composite. An index is a group of stocks, bonds, or other securities that are used as a benchmark for measuring the performance of a market or sector.

Index investing involves purchasing a portfolio of securities that closely mimics the holdings of an index. For example, if the S&P 500 index has 500 stocks with a weight relative to each company’s size.

Index investing can be done through mutual funds, exchange-traded funds (ETFs), and other types of investment vehicles.

What are the main benefits of index investing?

Index investing has several benefits that make it an attractive investment strategy for many investors. Some of the main benefits of index investing include:

• Low costs: Index investing typically involves investing in index funds or exchange-traded funds (ETFs), which have lower fees and expenses than actively managed funds. This can result in significant savings over time, as lower fees mean more money in the investor’s pocket.
• Diversification: Index investing allows investors to achieve broad market exposure by investing in a diversified portfolio of securities that track a specific index. This can help to reduce risk and volatility, as the investor is not exposed to the risks of individual securities or sectors.
• Consistency: Index investing involves following a predetermined investment strategy that doesn’t involve making frequent changes or market timing decisions. This consistency can help investors stay focused on their long-term investment goals, rather than getting caught up in short-term market fluctuations.
• Transparency: Index investments, such as index funds and ETFs, are generally more transparent than actively managed funds. Investors can easily see the holdings of the fund and the fees they are paying, which can help them make informed investment decisions.
• Accessibility: Index investing is accessible to a wide range of investors, as many index funds and ETFs have low minimum investment requirements. This can make it easier for new investors to get started with investing, as they don’t need to have a large amount of capital to get started.

Overall, the benefits of index investing make it an attractive option for many investors who are looking for a low-cost, diversified, and consistent investment strategy.

Are there any tax advantages of index investing?

Index investing can offer certain tax advantages over other investment strategies.

• Lower capital gains taxes: Because index investing involves buying and holding securities for the long term, investors are less likely to trigger short-term capital gains taxes, which are taxed at higher rates than long-term capital gains. In addition, index funds and ETFs tend to have low portfolio turnover, which means fewer capital gains distributions that can trigger taxes.

What is an ESG index fund?

An ESG index is a stock market index that tracks companies that score well on environmental, social, and governance (ESG) factors. These indices are designed to reflect the performance of companies that meet certain ESG criteria, such as having a positive impact on the environment, treating their employees fairly, and having transparent and accountable corporate governance practices.

ESG indices are often used as a basis exchange-traded funds (“ETFs”) which are simply investment funds traded on stock exchanges. By investing in an ESG index ETF, investors can gain exposure to companies that are more socially responsible and environmentally sustainable while at the same time taking advantage of all the benefits of index investing such as low costs.

There are a variety of different ESG indices available, each with its own methodology and criteria for selecting companies. Some ESG indices may use a screening process to exclude companies that engage in activities that are deemed harmful to the environment or society, while others may use a scoring system to rank companies based on their ESG performance.

Why would an investor use an ESG index fund compared to actively managing their ESG investment portfolio themselves or by using an investment advisor?

Investors may choose to use an ESG index fund over actively managing their ESG investment portfolio for several reasons, including:

• Lower costs: ESG index funds are typically less expensive than actively managed ESG portfolios. This is because index funds simply track an underlying index, while actively managed funds require a team of portfolio managers and analysts to select and manage the portfolio’s investments. As a result, index funds tend to have lower fees, which can translate into higher returns for investors over the long term.
• Diversification: ESG index funds provide investors with exposure to a diversified portfolio of ESG-compliant companies. By investing in an ESG index fund, investors can gain exposure to a broad range of companies that meet their ESG criteria without having to conduct extensive research and analysis on individual companies.
• Consistency: ESG index funds provide a consistent approach to investing in ESG-compliant companies. The fund’s portfolio is based on a pre-determined set of ESG criteria, which means that the portfolio is unlikely to deviate significantly from those criteria over time. This can help investors to stay focused on their long-term investment goals and avoid the temptation to make impulsive investment decisions based on short-term market fluctuations.
• Transparency: ESG index funds are more transparent than actively managed funds, as their holdings are based on a pre-determined index. Investors can easily see which companies the fund is invested in, and how those companies rank on ESG criteria. This transparency can help investors make informed investment decisions and better understand the potential risks and returns of the fund.
• Time-saving: ESG index funds can save investors time compared to actively managing their ESG portfolio. With an index fund, the investor does not need to research and select individual securities or monitor the portfolio’s performance on an ongoing basis. This can be especially beneficial for investors who may not have the time or expertise to actively manage their investments.

Who determines what goes into an ESG index?

The specific methodology for determining what goes into an ESG index can vary depending on the index provider. However, there are a few common approaches that are often used to determine the constituents of an ESG index:

• Inclusion/exclusion screening: ESG index providers may use a screening process to identify companies that meet certain ESG criteria and exclude companies that do not. For example, a provider may exclude companies involved in weapons production or tobacco sales, or include companies with strong records on climate change, diversity, and human rights.
• ESG scores: Some ESG index providers use a scoring system to rank companies based on their ESG performance. These scores may be based on a range of factors, such as a company’s carbon emissions, labor practices, or governance structure. Companies with high ESG scores are typically given more weight in the index.
• Industry-specific criteria: ESG index providers may also consider the specific ESG risks and opportunities associated with different industries. For example, an ESG index for the energy sector may have different criteria than an ESG index for the technology sector, reflecting the unique ESG challenges facing each industry.

Once an ESG index provider has determined the criteria for selecting companies for the index, they will typically use a rules-based approach to construct the index. This may involve using an algorithm or formula to weight the companies in the index based on their ESG scores or other criteria.

It’s important to note that the specific criteria used to determine the constituents of an ESG index can vary depending on the index provider. So, below we review the methodology used by MSCI, which is a leading ESG index provider as an example.

Example: MSCI ESG Indexes

MSCI is a global indexing leader. The company offers a wide range of index products including ESG indexes.

MSCI’s ESG framework is designed to study the financial significance of ESG issues. Their methodology aligns with the fiduciary duty that most investment professionals have. Since, not only do they need to deliver financial returns for their stakeholders, they also need to align their investments with ESG criteria.

MSCI ESG ratings look like a credit ratings scale. CCC and B are considered “laggards” (or “junk” in credit ratings parlance), BBB, BB, and A are considered “average”, and AA and AAA are considered “leaders”.

The result of MSCI’s ESG framework are three relevant indexes that ESG investors can use depending on how strict their ESG values are, called:

• MSCI ESG Aware
• MSCI ESG Leaders
• MSCI ESG Advanced

Which index is best for your portfolio depends on your individual values and investment objectives. Here are the differences:

MSCI ESG Aware – includes companies that are benchmarked to broad markets with explicit tracking error constraints. They include exclusionary screening for severe controversies and material involvement in several businesses with higher ESG risk. MSCI ESG Aware is the least strict of the three MSCI ESG indexes and includes oil & gas companies in the index. This index will most closely resemble the broad market non-ESG index.

MSCI ESG Leaders – provides targeted exposure to the equities of companies demonstrating leading sustainability business practices in every sector. The MSCI ESG Leaders index contains companies of every sector to create balanced portfolios, broadly representative of underlying markets. This means the index includes companies in the energy sector but excludes oil sands companies.

MSCI ESG Advanced – this ESG index includes companies with high ESG quality scores regardless of industry sector. The MSCI ESG Advanced index provides for extensive exclusionary screening for material involvement on a wide range of businesses with potentially higher ESG risks. This means a significant focus on climate related investment risk through the exclusion of companies in the fossil fuel industry. The MSCI ESG Advanced index is the strictest of the MSCI ESG indexes and does not contain any conventional energy companies and excludes most electric utilities that are producing energy using conventional sources. Although the MSCI ESG Advanced index includes conventional mining companies.

What’s the best ESG ETF in Canada?

Name	Symbol	MER	Bid/Ask Spread
iShares ESG Advanced MSCI Canada Index ETF	XCSR	0.17%	0.81%
TD Morningstar ESG Canada Equity Index ETF	TMEC	0.11%	1.00%
BMO MSCI Canada ESG Leaders Index ETF	ESGA	0.17%	0.88%

Most ESG investors I’ve met would like to exclude oil & gas companies from their investment portfolio. Like myself, many would also like to exclude mining companies too. So, this makes the iShares ESG Advanced MSCI Canada Index ETF is the best choice.

The fees for the three ESG ETFs listed in the table above are all relatively low. Not as low as broad market index ETFs, but still low historically speaking, and relative to most other ETF strategies. Click here to read my post on the cheapest broad market index ETFs in Canada.

What are the differences between these ESG ETFs and broad market indexes?

The iShares ESG Advanced MSCI Canada Index ETF excludes all energy companies and all electric utility companies that generate electricity from non-renewable sources. This makes it the most appealing to strict ESG investors. The result is that the index is heavily weighted towards financials, which make up almost half of the portfolio compared to 33% of the broad market index.

The TD Morningstar ESG Canada Equity Index ETF isn’t suitable for investors wanting to screen out oil & gas companies. For example, conventional energy companies make up 15% of the portfolio, with Enbridge, Suncor, and TC Energy all making the top 10. So, if you don’t think the oil sands are sustainable, then avoid this ETF.

Why include the BMO MSCI Canada ESG Leaders Index ETF in this comparison?  After-all, it includes oil & gas companies and doesn’t go as far to screen for the highest ESG ratings. Well, investors should pay attention to costs. With a low MER, investors who use BMO Investorline will also receive commission free trades on this ETF. This is a big cost savings.

How else can you use these ESG ETFs?

• Benchmarking
• Deconstruction & Customization
• Shareholder Activism

Investors can use ETFs and index funds to benchmark their returns.

The simplest way to use an ETF or index fund as a benchmark is to compare its returns to the returns of an actively managed investment portfolio. For example, an investor could compare the returns of a mutual fund to the returns of a similar ETF or index fund. If the ETF or index fund consistently outperforms the actively managed fund, this may indicate that the actively managed fund is not generating enough returns to justify its higher fees.

Can an investor use the holdings that an ETF lists on their website to construct their own tracking portfolio with the same stocks?

Yes, an investor can use the holdings listed on an ETF’s website to construct a tracking portfolio using the same stocks. The holdings of an ETF are typically updated regularly, so an investor can use this information to create a portfolio that closely tracks the performance of the ETF.

What if an investor uses the list of holdings of an ETF to construct their own portfolio, and then engages an activist shareholder to advocate for specific issues on their behalf?

This is the holy grail of sustainable investing in public stocks. First, an investor will identify their values, and then build an investment policy that screens out companies that don’t meet their ESG criteria. Then, an investor can use ESG ETFs to create a custom portfolio of individual stocks. Once this portfolio has been built, its largely passive. The investor can then engage an activist shareholder service such as SHARE Canada to press the companies in their portfolio for specific issues (like better governance, worker’s rights, and to realize other social & environmental goals).

Our family office has a keen interest in finding ways to improve the performance of your investment portfolio that does not involve picking stock A or stock B. We do this by employing time-tested investing techniques that include creating Investment Policy Statement for each of our clients, employing buy-and-hold investment philosophies, and by holding our investment managers to account.

If you would like more information about the services we provide, please click here to contact us.