Here's What You Need to Know About Sustainable Funds

Interested in sustainable investing? We look at how to pick apart the different ways funds that consider environmental, social and governance (ESG) factors 

Karen Wallace 07/04/2020 09:11:00
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Sustainable investing can be a difficult concept to get your head around.

First off, there are a lot of terms that seem synonymous, or a used interchangeably - sustainability, ESG, impact investing and responsible investing, to name just a few. There are also some very pervasive myths; many people believe they will have to sacrifice returns if they invest in line with their beliefs, so they figure they should just hold their nose and stick with conventional investments. But that's not true.

If confusion is the biggest thing holding you back from sustainable investments, read on. Here we'll guide you through how we classify sustainable funds and how to use Morningstar research to evaluate these investments by yourself. 

1. Learn the Terms

Let’s start with the big one: sustainable investing. At Morningstar, we frame sustainable investing as an overarching investment approach that incorporates environmental, social, and corporate governance criteria throughout the investment process. 

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Environmental factors include company behaviour and policies on issues such as climate, pollution, energy efficiency and renewable energy. The social factor evaluations things like a company's commitment to inclusion and diversity in its workplace, fair wages, forced labour, supporting the local community, customer privacy, and product safety. Finally, the governance factor measures aspects such as executive pay, political donations, bribery and corruption, and board-level attention to sustainability and climate issues. 

Let's pause for some mythbusting. Raise your hand if you think the crux of sustainable investing involves aoviding "problem" stocks such as tobacco or gun companies.

This method, known as negative (or exclusionary) screening, used to be stanard amaong socially responsible funds, which were an early version of sustainable funds that were around in the 80s and 90s. And while negative screening is still used today, especially by funds investing in line with religious values, a problem with using the approach exclusively is that it rules out prominent companies for non-financial reasons, and that can lead to underperformance. 

These days, many sustainable funds take a more integrative approach to building a portfolio. The emphasis is on identifying stocks that have so-called “best-in-class” practices when it comes to addressing ESG issues relevant to that particular company. It tilts the portfolio toward companies that are better at managing ESG issues than their peers and therefore less likely to face financial risks such as fines, lawsuits, and reputational damage.

2. Types of Sustainable Fund

An increasing number of funds state in their prospectus (the document all funds must publish as a guide to their investment strategy, costs, risks and management) that they consider ESG factors as part of their investment process. But beyond stating that ESG factors are "considerations", these funds typically don't use exclusionary screens, impact analysis or shareholder engagement as a formal part of their process. We call these ESG Consideration funds. 

By contrast, ESG Focus funds are those that make sustainability factors a featured component of their process when building their portfolio and choosing investments. 

A third group, Impact funds, focus on broad sustainability themes and on delivering social or environmental impact alongside financial returns. Impact funds often focus on specific themes, such as low carbon, gender equality, or green bonds (which fund new and existing projects with environmental benefits). 

Finally, there are Sustainable Sector funds, which focus on companies that contribute to, and aim to benefit from, the transition to a green economy in areas such as renewable energy, energy efficiency, environmental services, water and green real estate. 

3. Putting Your Knowledge to Work 

Unfortunately for investors, there is little consistency in the way that sustainable funds are named. Most funds that emphasise their consideration of ESG factors are marketed as sustainable offerings and include key terms like "ESG" or "Sustainable" in their names. 

Let’s say you are interested in buying XYZ Select ESG Fund. According to the fund’s prospectus and its description on the fund company’s website, XYZ Select ESG is an actively managed fund that seeks companies with healthy balance sheets, good growth prospects, and leading environmental, social, and governance practices.

The next step in your consideration process should be to analyse how well the fund is actually delivering on these promises.Morningstar ratings can help you can do that. The Morningstar Sustainability Rating measures a fund portfolio's overall exposure to ESG risks. 

The rating works like this: First, it measures the degree to which individual companies in the portfolio face financial risks from ESG issues, then it rolls those individual scores up into an overall, portfolio-level score. The rating is easy to interpret: 5 globes means the overall portfolio has low ESG risk; 1 globe means it is exposed to significant ESG risk.

globe rating

Another useful tool is the Morningstar Low Carbon Designation, which evaluations how well companies in the porfolio are managing their exposure to climate risk by limiting carbon emissions and minimising the costs of switching to new technologies. The rating rolls each company's risk score up into a portfolio-level score. 

The Morningstar Low Carbon logo can help identify funds with low carbon transition risks and low fossil fuel exposure.

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Karen Wallace  Karen Wallace is an editor with Morningstar.

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