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Sustainable Investing

article by SSGA

How to Build an ESG Core When Harvesting Losses

By Matthew J Bartolini, CFA, CAIA Head of SPDR Americas Research

Oct 21, 2022

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.

Matthew J Bartolini, CFA, CAIA, 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

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

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.

¹ Bloomberg Finance, L.P. as of 8/3/2022.
² Based upon the breakdown of emerging, developed, and US regions within the S&P Global BMI Index as of 8/3/2022.
³ Bloomberg Finance, L.P., as of August 8, 2022.
⁴ Based upon a fixed income portfolio benchmark using the Bloomberg US Mortgage Backed Securities (MBS) Index for Mortgages, Bloomberg US Treasury 3-10 Year Index for US Treasuries, and the Bloomberg US Corporate Bond Index for US Corporates.

View Disclosure

Bloomberg US Aggregate Bond Index
Measures the performance of the U.S. dollar denominated investment grade bond market.

Bloomberg US Corporate Bond Index
Measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by US and non-US industrial, utility and financial issuers.

Bloomberg US Mortgage Backed Securities (MBS) Index
Tracks fixed-rate agency mortgage backed pass-through securities guaranteed by Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC).

Bloomberg US Treasury 3-10 Year Index
Measures US dollar-denominated, fixed-rate, nominal US Treasury debt with 3-10 maturities.

Environmental, Social, Governance (ESG)
ESG investing involves the assessment of material environmental, social and governance
opportunities or risks1 (together “ESG Factors”) during the investment process.

S&P 500® Index
A market-capitalization-weighted stock market index that measures the stock performance of the 500 largest publicly traded companies in the United States.

S&P Small Cap 600® Index
A market-capitalization-weighted stock market index that measures the stock performance of the 600 publicly traded small cap companies in the United States.

S&P® Developed Ex-U.S. BMI Index
A market capitalization weighted index designed to define and measure the investable universe of publicly traded companies domiciled in developed countries outside the United States.

S&P® Emerging BMI Index
A market capitalization weighted index designed to define and measure the investable universe of publicly traded companies domiciled in emerging markets.

Tax-Loss Harvesting
Selling investments in taxable accounts that have lost value to offset capital gains elsewhere and help reduce taxes owed.

The views expressed in this material are the views of the SPDR Research and Strategy team through the period ended August 3, 2022 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.

The information provided does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your tax and financial advisor.

Past performance is not a reliable indicator of future performance.

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Data in tables have been rounded to whole numbers, except for percentages, which have been rounded to the nearest tenth of a percent.

Investing involves risk including the risk of loss of principal.

Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates raise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

Equity securities may fluctuate in value and can decline significantly in response to the activities of individual companies and general market and economic conditions.

Concentrated investments in a particular sector or industry tend to be more volatile than the overall market and increases risk that events negatively affecting such sectors or industries could reduce returns, potentially causing the value of the Fund’s shares to decrease.

The returns on a portfolio of securities which exclude companies that do not meet the portfolio's specified ESG criteria may trail the returns on a portfolio of securities which include such companies. A portfolio's ESG criteria may result in the portfolio investing in industry sectors or securities which underperform the market as a whole.

Companies with large market capitalizations go in and out of favor based on market and economic conditions. Larger companies tend to be less volatile than companies with smaller market capitalizations. In exchange for this potentially lower risk, the value of the security may not rise as much as companies with smaller market capitalizations.

Investments in small-sized companies may involve greater risks than in those of larger, better known companies.

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International Government bonds and corporate bonds generally have more moderate short-term price fluctuations than stocks, but provide lower potential long-term returns.

Investments in asset backed and mortgage backed securities are subject to prepayment risk which can limit the potential for gain during a declining interest rate environment and increases the potential for loss in a rising interest rate environment.

Frequent trading of ETFs could significantly increase commissions and other costs such that they may offset any savings from low fees or costs.

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