In the Financial Independence world, broadly based low-cost index fund investing is central to the idea of building wealth on an average salary. From what we’ve found, there is little to no thought about the impact that our investments are having on climate change.
In this post, we’ll cover:
- The basics of low-cost index fund investing
- Why expense ratios really matter
- The problem with broadly based low-cost index funds (VTSAX)
- Options to incorporate sustainable investing into your portfolio
Low-cost Index Fund Investing
Traditional financial independence principles direct us to invest in low-cost index funds. When you invest in an index fund, you’re essentially buying a piece of tens, hundreds, or even thousands of publicly traded companies at the same time. You are investing across a broad spectrum of the market, protecting yourself from risk. Most investors call this diversification. If one company fails, another one will take its place. This is a popular strategy because you are effectively investing in the entire market, as opposed to one stock at a time, and the market is pretty resilient.
Take the darling fund of the Financial Independence movement: VTSAX. The historical return of VTSAX over the last 10 years is 13.64%, that’s a huge return. The market has been through several crashes since the fund began in 1992, and VTSAX has bounced back every time (because the US stock market bounced back every time).
Low expense ratios are key
Not only is VTSAX invested across the entire market, but it also has an incredibly low expense ratio, which is perhaps the most critical aspect of investment choices that people overlook. The expense ratio for VTSAX is 0.04%. Compared to other funds, this is VERY low. Many funds are 1% or higher, especially if you wander into the actively managed funds.
To demonstrate the importance of expense ratios, here’s some math:
Here are our assumptions:
We are making an initial investment of $10k.
We are contributing 30k annually for 30 years.
The expense ratio of fund #1: 0.04%
The expense ratio of fund #2: 1.00%
Both funds have a 6% annual rate of return.
After 30 years:
Fund #1 will cost you: $17,278.97
Fund #2 will cost you: $392,795.65
As you can tell, expense ratios really matter.
How ridiculous is that?! If you’re not familiar with investing, a 1% fee may seem so small that it’s insignificant in the grand scheme of things. But why is the cost so much higher?
This can be boiled down to opportunity cost. When you pay a fee, the money is coming directly out of your investment, so you’re losing the opportunity to earn compounding interest on that fee. Over 30 years, it adds up!
If you want a much more detailed account of why low-cost index funds are arguably the best option if you wish to pursue financial independence, we recommend checking out the stock series by JL Collins.
The problem with broadly based, low-cost index funds
At Saving Our Green, we currently are invested in broad-based index funds, with a significant portion in VTSAX. But as we’ve come to realize, the unfortunate downside of investing in these funds is that there is usually no consideration towards sustainability or social responsibility. What we mean by this is that many of the companies in the VTSAX portfolio are not socially and environmentally “good” companies.
For example, in VTSAX, Johnson & Johnson is the 9th largest holding. They have been in the news a lot lately for their harmful role in the opioid epidemic. Additionally, since before we were all born, they have knowingly been selling baby powder that causes cancer (though they still deny it, it has been proven in the courts).
Another company in VTSAX, Exxon Mobil, which is the 11th largest holding, is not only one of the world’s largest fossil fuel producers but also has a long history of funding efforts to deny the impact of climate change to protect their business.
Let’s plug VTSAX into the tool:
The results show that 8.44% of VTSAX is invested in the fossil fuel industry. That might not sound like a lot, but keep in mind that this number is ONLY the percentage invested in fossil fuels. This doesn’t bode well if you care about sustainable investing.
Take a look at the rest of their report card:
Thus, we’re at an impasse here. We can make lots of money off of these companies, but do we really want to fund them with our investments? Money is a fantastic motivator. If we’re going to influence change, we need to put our money where our mouth is.
Options for Sustainable Investing
Socially responsible investment funds are supposed to be the solution to this problem. But the solutions available right now are not as good as funds that don’t take sustainability into consideration. Generally, either the performance of sustainable funds is low and unpredictable compared to the mainstream index funds, or the returns are great, but the fees are too high.
This is why sustainable investing is arguably the most challenging part of working towards financial independence and sustainability. We need to make a financially risky choice here. However, that’s not to say that sustainable investment funds haven’t become a viable alternative for people working towards financial independence.
So what do we do?
There’s no one ideal solution, but we do have a few options. Before making any decisions, please consult your financial advisor, as we are not experts. We can only speak to our own experience and research.
Option 1: Invest in current sustainable index funds with optimism.
Granted, this option all the problems that we stated before. But, with the increasing demand for socially responsible index funds, they will only be improving. Find an index fund that pledges to continually research and enhance the funds within the portfolio.
Vanguard has been adding more ETFs and Index funds. As of 2020, they currently have 4 in their portfolio:
- Vanguard ESG U.S. Stock ETF (ESGV) – 0.12% expense ratio
- Vanguard ESG International Stock ETF (VSGX) – 0.17% expense ratio
- Vanguard Global ESG Select Stock Fund Investor Shares (VEIGX) – 0.55% expense ratio
- Vanguard FTSE Social Index Fund Admiral Shares (VFTAX) – 0.14%
Compared to VTSAX, these fees are 4-5 times higher. But compared to the other SRI funds on the market, which tend to be actively managed, these are far cheaper.
Another increasingly popular route would be to use a robo-advisor. You have a few options here, which we will review in-depth on a later post. Betterment, Wealthsimple, OpenInvest, and Motif all have SRI auto-invest solutions.
The Betterment SRI fund has committed to continually improve its responsible investing portfolio as new data emerge.
Today, our SRI portfolio reflects a 42% improvement to social responsibility scores for our US large-cap holdings when compared to our core portfolio. In the future, we will improve our SRI portfolio even further, iterating and adding new SRI funds that satisfy our cost and diversification requirements as they become available.
Of course, 42% improvement isn’t ideal, but it’s definitely a step in the right direction. Sustainable investing has come a long way in recent years, and the increasing number of options is proof.
Option 2: Create your own sustainable investing portfolio.
You could create your own portfolio in which you buy and sell individual stocks that are 100% socially responsible. Because of the manual nature of it, this option will take much more work to be successful and maintain. Not to mention, you would be hard-pressed to find ANY publicly traded company that is 100% socially responsible. Or at least one that is publicly traded.
The team at As You Sow has put together a screening system to evaluate global publicly-traded companies on the “cleanliness” of their operations. Using this screening system, they compiled a list of the top 200 companies generating at least 10% of their revenue from clean energy sources.
The screening system takes into account many factors having to do with sustainability. Check out the latest report and list of clean 200 companies, as well as how their methodology in determining the agenda.
So far, no ETF or Index fund tracks the Clean 200 list precisely, so it would be possible to assemble your own portfolio comprised of these companies.
Option 3: Put your money elsewhere.
You could just avoid investing in the stock market altogether. Instead, put your money into other assets, like real estate or local businesses that support your values. As a more hands-off approach, you could invest in real estate investing platforms like Fundrise, or a publicly traded Real Estate Investment Trust (REIT). However, make sure you read into the fees on those.
When a sustainable investing option that fits your comfort level becomes available, move your money then.
Sustainable investing as the path forward
If we put our money into these socially responsible options, we are influencing change that will benefit society and ensure our survival and the survival of our children. Since SRI options are becoming increasingly mainstream, we don’t have to sacrifice our financial future to do it.
I don’t know about you, but I’ll sleep better at night knowing what little money I have is going towards a good cause.
What are some other options for sustainable investing that you’ve found? Let us know, we want to explore every possibility!