How to Build an Ethical Investment Portfolio for FIRE
One of the trickiest and most important steps in the pursuit of fire is working out how to invest. Once you’ve determined your FIRE goal, it’s time to actually work out how to get there. Should you invest in ETFs* or LICs**? What mix of Australian vs. International shares should you go for? Should you buy bonds? It can be really overwhelming!
This post aims to lay out a simple way to approach this issue, the three fund portfolio, and how to do it ethically. This is not personal financial advice, nor is it the only way to invest for FIRE. Rather, it’s one way to invest for stability, and the long term, and a method which we’ve found has been working for us.
Building a portfolio, where should I start?
There are many places you can begin your investment journey for FIRE, but if you’re just starting out, it’s likely you’re keen to establish a solid and simple base that you can build upon as your investing knowledge and experience increases. To me, the simplest and most reliable base is the three fund portfolio.
The idea of the three fund portfolio is very simple, just like a three-legged stool, it’s stable, and it achieves this by investing in three simple ways: an Australian stock market ETF, an international stock market ETF, and a bond ETF. This provides balanced exposure to the Australian market, the international market, and bonds.
One of the biggest questions to ask when setting up a three fund portfolio is, ‘What should my split of the three ETFs be?’ More conservative investors will go for something like a 60:40 split, which means they’ll have 60% in stocks and 40% in bonds. Aggressive investors may have an 80:20, or 90:10 split, and some even just go 100% stocks.
A good place to start in this decision is to complete Vanguard’s Investor Questionnaire. When you do, you’ll receive a recommendation like: ‘Suggested Allocation (“20% Bonds & 80% Stocks”)’, which you can consider as a good starting point for how you may like to allocate your funds to start off with.
It’s important to emphasise that this is just a starting point. Both the Vanguard questionnaire and this blog don’t constitute personal financial advice. Equally as important, in the words of Howard Marks of Oaktree Capital, “Scared money never wins”***, so even if Vanguard suggests an 80:20 portfolio, take a look at the historic volatility and return of different 3 fund portfolio mixes and ask yourself how much volatility you’re truly happy with.
See here fore the Bogleheads Wiki if you’re keen to learn more about the three fund portfolio.
Which ETFs should I buy?
Once you have a decent idea of your mix of stocks to bonds, it’s time to work out which ETFs are likely a good fit for you. For a comprehensive overview of of all of the ETFs available on the ASX (the Australian stock exchange), a great place to go is ETF Watch, who produce an in-depth guide each year. But if you’re new to ETFs, you may find the range a bit overwhelming. I’ll write a post soon on key factors to consider when selecting an ETF. For the purposes of this post, I’ll restrict the discussion to only ‘ethical’ ETFs.
Here is a table of all of the ‘ethical’ ETFs available on the ASX at the time that I’m writing this post (source).
There’s quite a lot to choose from, and Ms. FWM and I spent quite some time going through each of these with a fine tooth comb. The things we were looking at most closely in each case were the ‘screens’ and the ‘holdings’.
Ethical Screens
‘Screens’ are the things that the ETF chooses to filter companies based upon. For example, VESG, the vanguard Ethical ETF, ‘offers low-cost access to a broadly diversified range of securities that excludes companies with significant business activities involving fossil fuels, nuclear power, alcohol, tobacco, gambling, weapons, adult entertainment and a conduct related screen based on severe controversies.
This means they won’t invest in these types of companies. The easiest way to find the ‘screens’ that a company uses is to google “ETF Name + Factsheet”. This will bring up a PDF of key information about that ETF and the screen information will usually be under the ‘ETF Overview’ heading at the top, like this.
Holdings
‘Holdings’ represent the underlying companies contained within the ETF. Through looking at different ‘ethical’ ETFs over a number of years, it’s become clear to Ms. FWM and I that this is where you really find out whether an ETF fits into your own personal understanding of what ‘ethical’ means.
For example, here are the holdings of VESG (again from their factsheet).
This may fit well for you, but for us this didn’t seem to be very ‘ethical’. For example, Amazon is renowned for its poor treatment of workers, Facebook clearly doesn’t take the privacy of its users very carefully, and Nestle has a pretty horrendous history of unethical practices.
Ms. FWM and I looked through the factsheets for all of the ethical ETFs listed above and in the end we were only really happy with the holdings in two of them, Betashares’ FAIR and ETHI (no affiliation or kickback from Betashares)
FAIR aims to provide ethical exposure to the ASX.
The goal of ETHI is to provide an easy way to invest in the U.S stock market. Here are ETHI’s holdings.
Now, I’m not going to lie, there are issues with both of these ETFs. The first main issue is diversity. FAIR only has 81 holdings and it’s heavily weighted (29.7%) towards Australian healthcare. ETHI has 199 holdings and is pretty tech heavy. The second main downside is that ETHI isn’t a truly global ETF, it’s only the US. In a three fund portfolio, we’d ideally have our ‘international’ holding being truly international. But at present, none of the global ETFs listed on the ASX are sufficiently ethical for Ms. FWM and I, so we’re happy to go with ETHI and FAIR until another option comes along.
To us these downsides are significant, but they’re outweighed by the importance to us for our investments to be aligned with our values. I am by no means saying that these are the only truly ethical ETFs, or the only ETFs that you should invest in. Rather, I hope that your main takeaway from this section is, ‘Don’t believe the label on the packet’. Just because something is labelled ‘ethical’, it doesn’t mean that it matches what you believe is ethical. It’s really important to go to an ETF’s factsheet, to actually looking at their holdings, and to check whether that ETF aligns with what’s important for you and your values personally.
For our bond ETF we’ve gone with Betashares’ GGOV, which is a global government bond ETF. Betashares does also have an ‘ethical’ bond ETF, GBND, but to us there’s no ethical issue with investing in global government bonds (via GGOV), so we didn’t feel that the hefty management fee on GBND as being worth it.
EDIT: As of 2021, three new offerings are on the market worth noting. Each of these (DBBF, DGGF, and DZZF) are diversified offerings from Betashares that offer basically what we’ve built here, FAIR, ETHI, and some bonds, but all in one neat packet and at a lower combined management fee! Ms. FWM and I will be going with DZZF from now on! Thanks to CFWM reader Chris for pointing out these options to us!
Yeah, but the fees are huge!
The elephant in the room that I need to address is the high fees of ethical vs. standard ETFs. By way of comparison, here’s FAIR and ETHI against much cheaper standard options.
FAIR management fee: 0.49%,
Comparison – Betashares Australia 200 ETF (A200) management fee: 0.07%
ETHI management fee: 0.59%,
Comparison – Vanguard MSCI Index International Shares ETF (VGS) management fee: 0.18%
A200 and VGS are the two ETFs that we’d probably use to construct our three fund portfolio if we weren’t pursuing the ethical route, which is why I’ve used them for this comparison.
Looking at percentages are all well and good, but what kind of dollar impact is this likely to make in the long term?
Over the long term, the main difference in return between FAIR and ETHI and their standard counterparts probably won’t be to do with the fees, but instead due to the movement of the underlying assets. Some argue that ethical fund perform better in the long term, but let’s set that argument aside for the moment and consider what the impact would be if the only difference between the ethical and the standard funds were their fees.
The average fee for ETHI and FAIR combined is 0.54%
The average fee for A200 and VGS combined is 0.125%
The difference between these two fees is 0.415%
If the market return we expect in the standard investing world is 7% p.a, this means if the ethical funds underperform the market by fees, we could expect a return of around 6.59%
I’ll roughly model the impact of these fees on our plan for Financial Independence (starting value $200k, add $3k per month, invest for 20 years). Hopefully this should make it clear how you can do the same for your situation.
Investing in standard funds with a 7% return p.a.
Investing in ethical funds with a 6.59% return p.a
The difference is $2,370,528-$2,231,750= $138, 778, or 5.8% overall.
I’m not going to lie, this is a pretty big deal. This is several years worth of living expenses. Ms. FWM and I had some long chats about this and, in the end, we decided that if this is the impact, we’re ok with it. Taking this approach doesn’t stop us from reaching FI, and it will enable us to do it in line with our values. If we’re happy to compromise our values to get ahead financially, the line representing how far we’re willing to go becomes more and more blurry.
But, it’s isn’t necessarily this bad… FAIR and ETHI have actually been doing pretty well!
The impact may well not be this large, results to date certainly don’t suggest that these standard ETFs will necessarily outperform FAIR and ETHI.
For example, FAIR was established on 27 Nov, 2017, and $10,000 invested then would be worth $11416 today. That same amount invested in a standard counterpart**** at the same time would today be worth only $10041.
ETHI was established on 5 Jan, 2017, and $10,000 invested then would be worth $16165 today, whereas $10,000 invested in VGS on 5 Jan, 2017 would today be worth only $13201 today!
Both of these results don’t include dividends, but dividends wouldn’t make up this gap anyway. In short, we’re happy to take a financial hit for our out attempt to invest in line with our values, but it looks like we might not have to!
Final words: Why invest ethically?
The goal of FIRE is a noble one; achieving financial independence and gaining the freedom to spend life as one wishes. But, as can be seen in the writings of some who have actually reached FIRE, finally getting there can be unsettling. Suddenly the stability and routine provided by a job can fall away, and people can find themselves asking, ‘Why did I do this? What’s all of this for?’
To me, the idea of an ethical approach to FIRE is about bringing this question of, ‘Why?’ into the present. Rather than leaving it to be dealt with by some future self who’s living it up, it’s about asking ourselves here and now what we’re trying to achieve with our limited lives, and how we want to achieve it. One thing that Ms FWM and I are keen to do in early retirement is dedicate more time to volunteering, and we see philanthropy as an important part of our FIRE journey too. To us, it wouldn’t make sense to make unethical choices in order to get to FIRE if our goal is to spend time ‘doing good’ when we finally get there!
For us, ethical investment is also about acknowledging the position of privilege that Financial Independence puts us in. Once financial independence is reached, and we have more time to consider the state of the world and all those in it, the difference between that haves and the have-nots is likely to become more stark. In this position, I’d hate to feel that, in pursuing fire, I contributed to negative global outcomes, such as income inequality, poor treatment of workers, or environmental degradation. I feel it’s paramount that in pursuing independence for ourselves we ensure that we don’t take actions that reduce the possibility of others to live flourishing lives.
Regardless of your motivations for an ethical pursuit of FIRE, or whether you were just reading this article for the fun of it, I hope you now have: a better understanding of the ins and outs of ethical investing, increased knowledge of how to size up ethical ETFs, and a basic understanding of the idea of a three-fund portfolio as a stable basis from which to start your FIRE investing journey.
And once you’ve made your plan, make sure you stick to it! Let me know what you think in the comments, I’d love to know your plans for investing ethically!
Notes:
*ETF stands for ‘Exchange Traded Fund’. ‘Exchange Traded’ just means it can be bought and sold on the stock market, and the ‘fund’ part describes how it’s a combination of shares from many different companies. When you buy ‘an ETF share’ you actually buy a very very small slice of often hundreds of companies. This allows you to get the average return of all of those companies together, and reduces the risks associated with individual stocks.
**A LIC is a Listed Investment Company. These are like ETFs, but they often contain fewer stocks than ETFs and they’re managed by people, so you’re trusting the people to make good decisions about the companies that they include
***Hear Howard on the Tim Ferriss podcast here: https://tim.blog/2018/09/25/howard-marks/
****VAS. Almost identical to A200, but A200 didn’t exist yet in Nov 2017 so I can’t use it for comparison.