Choosing the Right Sustainable Fund

Though most sustainable funds are actively managed, the menu of passive sustainable funds has grown in number, size, and complexity over recent years. And so, too, has the due-diligence burden for investors.

The research recently published in our report, "Passive Sustainable Funds: The Global Landscape 2020," has shed light on some key considerations when choosing passive sustainable funds.

Is an Active or Passive Fund the Right Fit? The first question investors must ask themselves is whether an active or passive approach will best meet their needs.

Passive funds tend to be much cheaper than their active counterparts. This is not a minor point, as fees have been shown to be one of the most reliable predictors of future fund performance.

Another advantage of index investing is the transparency offered. Passive investors can see exactly what is held by the fund through an inspection of the index. That said, the opacity of some ESG metrics can mean the true reasons for inclusion or exclusion are still tricky to ascertain.

On the other hand, some believe that, in its purest form, sustainable investment can be implemented only by active managers. In some ways, the rigid nature of passive investing does not lend itself to the nuanced world of environmental, social, and governance considerations. For example, liquidity constraints mean that passive strategies must steer clear of smaller, often more impactful companies. Those seeking the most ESG impact might expect a level of engagement between fund management and portfolio company that is not possible in a passive wrapper.

Key Considerations When Choosing a Passive Sustainable Fund: Index/Strategy Analysis As with any passive fund, the assessment of a passive sustainable fund starts with the analysis of the underlying index. Not all sustainable indexes are created equal, and understanding the rules that govern them is crucial.

• Sustainable Focus. An investor must first determine whether the sustainable focus of the index and the metrics it uses are aligned with the ESG criteria that he wishes to emphasize. For example, there are many environmental metrics, such as carbon footprint, fossil-fuel reserves, green revenue, and so on. Different metrics reflect different company attributes, and the choice of one metric over another may lead to different index compositions. A lack of consensus on what constitutes a good ESG company means that it is also important to understand the sustainable scoring systems employed by the index provider. A company that can have a high ESG score according to one may have a poor ESG score according to another.
• Approach. As presented below, identifying whether the fund takes an exclusions-only, broad ESG, or thematic approach gives a strong indication of the role the fund should play in your portfolio. Exclusions-only funds tend to closely share the characteristics of a parent but also result in a lighter ESG flavor. Conversely, thematic funds, particularly those with a narrow focus, tend to have distinct risk and return drivers and are best used as satellite holdings.

Even within approaches, strategies can differ dramatically. Some funds look a lot like their starting universes, while others venture further from their starting points to offer strong exposure to ESG leaders. For example, MSCI Universal and MSCI SRI index strategies both use the same MSCI ESG scoring system, but the former heavily reweights a lightly screened parent index, while the latter selects only the top quartile of ESG scorers using market weights.

• Securities Selection and Weighting. It is important to understand the extent to which the fund is pursuing firms with strong ESG characteristics. A fund's securities selection and weighting approach has a big impact on the type of ESG exposure it delivers.
• Tracking Error. Tracking error and active share (a measure of the percentage of stock holdings in a fund's portfolio that differs from the benchmark index) both measure the level of active risk each fund takes versus its parent index. These are useful metrics for gauging how intensely a fund pursues ESG leaders and whether it might be appropriate as a core holding. There is trade-off between high ESG exposure on one hand, and broad diversification and low tracking error on the other. For example, those investors most committed to sustainability may favor the "purest" ESG exposure at the expense of a more-concentrated portfolio with higher tracking error. Investors seeking to replace a core portfolio allocation may be more willing to compromise on "purity" of ESG holdings (for example, accept less-compliant holdings) in exchange for retaining the benefits of diversification and lower tracking error.

Factors that affect tracking error include security-selection methodology, exclusions, and weighting schemes. Optimization techniques can be used to minimize tracking error. For example, the optimized MSCI ESG Focus and MSCI Low Carbon Target indexes aim for tracking error targets of 0.5% and 0.3%, respectively, for developed markets.

Persistent sector and geographic biases come from the fact that ESG scores tend to vary across geographies and sectors. For example, European companies tend to score well on many sustainability metrics, while emerging markets tend to score poorly. Some sectors, such as oil and gas, are prone to low overall ESG scores, while others, such as technology, may have higher ESG scores owing to the nature of the underlying businesses. Sector and geographic biases can affect performance relative to the broader market, even in the long run.

Key Considerations When Choosing a Passive Sustainable Fund: Fund Level Analysis The way in which a fund tracks its index also has sustainable implications.

• Fees. These are always a key consideration when analyzing funds. Sustainable passive funds tend to charge more than their nonsustainable peers. Some fee premiums can be expected, as there are undoubtedly costs associated with gathering robust ESG data and building a suitable sustainable investment strategy. That said, large fee differences between outwardly similar funds need to be justified.
• Securities Lending. This practice sees the fund lend out a portion of its holdings for a small fee. As part of the transaction, the fund receives a collateral basket. As above, if the type of collateral accepted is not restricted, the fund could end up holding non-ESG-compliant investments.
• Asset Manager. Active ownership, which includes proxy voting and engagement, is a key consideration at the fund group level. These efforts can involve voting on shareholder resolutions and opening dialogues with portfolio companies on ESG issues to enact change. Leaders in the space have detailed environmental and social proxy voting guidelines; a track record of putting forward ESG shareholder proposals and/or voting in favor of these types of resolutions; an outcome-oriented engagement strategy with a clear escalation strategy; and have disclosed voting records, rationales behind key votes, and engagement activities.

This article is adapted from research that was originally published in Morningstar Direct's Research Portal. If you're a user, you have access. If not, take a free trial.