Toward Sustainable Funds 2.0

After a decade of growth, it’s time to start talking about Sustainable Investing 2.0.

Sustainable investing represents a range of investment approaches that seek to generate competitive financial returns along with positive outcomes for people and planet.

It’s pretty basic from the demand side: More people today want to see large corporations treat their workers better. They want companies to take action to limit carbon emissions and position themselves to thrive in a low-carbon economy. They want less plastic pollution and deforestation. They want companies to be run by a more diverse group of people for the benefit of all stakeholders rather than by mostly white men for the sole benefit of shareholders. And so many of those who are fortunate enough to be investors (they are also workers and consumers and citizens) now want to be sustainable investors. All that has led to the runaway popularity of sustainable funds.

Why Traditionalists Are on the Defensive

Traditional investing, by which I mean the paradigm of the past half-century or so that puts shareholders first, is resistant to sustainable investing and unsure how to address the demand for it. The traditionalist response says investing should only be about maximizing returns at a given level of risk and that the purpose of public companies is to generate profits for shareholders. There is no room for normative views on how companies should behave or on their impact on other stakeholders and the planet. So long as companies are operating legally, this view goes, they should be free to maximize profits for shareholders, and investors should be satisfied with that. If they aren’t, they can put on their citizen hats and try to influence policy. Or they can don their philanthropist hats and donate to causes that address their sustainability concerns.

The traditionalist view ignores the impact of capital, particularly of equity ownership of public companies. Shareholders are also owners of companies. Today, they are starting to demand more of the companies they own, and at least some companies are coming to realize that embedding sustainability concerns into their business doesn’t destroy value—it creates value.

The traditionalist view also ignores the failure of public policy over the same time period that the shareholder primacy model has been dominant. During this time, corporations, their trade organizations and lobbyists, and super-rich individuals have leveraged their capital to successfully oppose regulation, reduce their taxes, and defund government. The traditional model finances problems, throws money at policymakers to make sure they ignore them, and then asks philanthropists to try to counter some of the negative manifestations of the problems out of their own pockets.

Not sustainable!

How Sustainable Funds Are Missing the Mark

So here we are, with more investors demanding sustainable investments, but who are the suppliers of most sustainable funds? They are the world’s largest asset managers, nearly all of which have attained that status by being successful at traditional investing. No wonder they struggle to come up with investment products that truly meet the preferences of sustainable investors.

Here are several ways that current sustainable investment funds miss the mark:

Reliance on ESG data and ratings. Many sustainable funds rely on environmental, social, and governance data to narrow their investment universe and then proceed to pick stocks in the way they have always done. Because few successful, growing companies show up as ESG laggards based on ratings, many ESG portfolios end up looking fairly similar to traditionalist portfolios that fish from the same pond.

Best-in-class and tilts. Mutual funds have achieved much of their success through diversification, which has, unfortunately, devolved into index-hugging for many active managers. Many ESG funds, active and passive, rely on “best-in-class” approaches that ensure indexlike exposure to every sector and industry, including those that have major ESG challenges. This leads to anomalies like the inclusion of the “best” oil company and tobacco company in some portfolios and the exclusion of, in the case of the S&P 500 ESG Index recently, a company like Tesla TSLA because other automakers score better on a measure of ESG that excludes product impact. Some ESG index funds, like the popular iShares ESG Aware exchange-traded funds, simply take a conventional index and “tilt” it toward companies that have better ESG scores but do not exclude any companies at all.

Sin-stock exclusions. Reflecting the views of faith-based investors in the late 20th century, many sustainable funds still exclude the trio of so-called “sin” stocks—alcohol, gambling, and tobacco. (A few have recently added cannabis to their exclusions.) While I suspect most sustainable investors have no issue with a tobacco exclusion because it is a product that, used as directed, kills millions of people every year, I doubt that exclusion of alcohol and gambling reflects the sustainability preferences that most people have today. Meanwhile, few sustainable funds exclude gun retailers, private prisons, or for-profit education providers.

And that brings us to fossil fuel exclusions. Because traditionalist investing has benefited immensely from diversification in general and fossil fuel investments in particular, asset managers are reluctant to offer sustainable funds that completely avoid fossil fuels. They are also slow to commit to allocations to renewable energy and clean tech because these emerging industries don’t fit neatly within the existing sector and industry structure and are therefore difficult to fit into asset-allocation models.

To address the energy transition, many asset managers claim the key is engagement with companies rather than exclusion. I generally agree, but when it comes to engagement, traditional asset managers are not being transparent enough about their engagement activities for investors to understand whether the engagement is making a difference. And while traditional asset managers seem to be voting more often in favor of ESG-related shareholder resolutions in recent years, they do not themselves sponsor or co-sponsor shareholder proposals.

So what’s to be done? It’s important to note that sustainable investors do have more open-end fund and ETF choices than ever. While these options clearly aren’t perfect, investing in them sends a clear signal to companies that they should attend to their ESG-related risks and that they should embrace sustainability as a value-creating principle going forward. But how could sustainable-investing products be improved? What would Sustainable Investing 2.0 look like?

Sustainable Investing 2.0

Here are some guidelines for asset managers as they develop the next generation of sustainable funds:

Don’t make ESG data and ratings do all the work. ESG metrics are important in examining the sustainability of a given company and industry, but they are more of a starting point than an end point for an investment decision. Every sustainable fund should have a clear concept of what companies belong in its portfolio. It should be something more than a company that meets a minimum ESG rating threshold.

Don’t ignore the broader impact of a company’s products, positive or negative. Standard ESG ratings and metrics mostly address the material ESG risks that could affect the company financially. Funds that rely on ESG ratings tend to ignore a company’s product impact. Impact is made easier to ignore because impact measurements are hard to come by, even though many ratings organizations are now feverishly working on impact metrics.

Don’t ignore the broader impacts of a company’s policies and behavior, positive or negative. A relatively small number of about 150 companies account for 80% of corporate industrial greenhouse gas emissions. Large retailers can set supplier standards that have huge impacts on thousands of companies in their supply chain. Major employers can set pay, benefits, and other workplace standards that are emulated by others, such as U.S. companies announcing this summer that they will pay for travel for employees to obtain abortions if they live in states where the procedure is now illegal. Many companies funnel money to politicians, campaign committees, and trade organizations, including some that pursue policies the companies themselves claim to oppose.

Don’t seek out only “good” companies for a sustainable portfolio and avoid “bad” ones. Sustainability is not black and white. It is nuanced, and public companies are on their own journeys. They need investors encouraging rather than discouraging their efforts. Choose a mix of all-around sustainability leaders, those that do well on managing their material ESG risks but need work to improve their impact, and those that make impactful products but need work on how they’re handling ESG issues in their operations.

Don’t ignore investment style. Value stocks may tend to have more ESG risk and impact issues than growth stocks, but sustainability can still be applied to value investing, and the wider availability of value-oriented sustainable funds helps investors diversify in a reasonable way.

Do have a coherent sustainability engagement policy that includes what sustainability issues are going to be raised—and why. Explain the desired outcome of engagements and the escalation strategy. Explain key proxy votes.

Do explain clearly the extent to which the fund invests in fossil fuel companies and the rationale for it or for excluding fossil fuel. Also explain how the fund is addressing the transition to renewable energy.

Do seek to be radically transparent about sustainable-investment strategies. Funds should make clear what approaches or combination of approaches to sustainable investing they use. They should provide the sustainability-related rationale for why each holding is in the portfolio, including any sustainability issues it has. They should provide examples of companies that failed to make it into the portfolio for sustainability reasons. Funds should produce impact reports that include both the impacts of portfolio holdings on people and planet, and results of an asset manager’s own engagement and proxy-voting activities.

Remember: Sustainable products generally are held to higher standards by consumers. These products are making the claim that they are better for the world than their conventional counterparts, so they need to make the case openly, honestly, and convincingly. The recent wave of sustainable funds has been reasonably successful at gathering assets, but addressing some of these issues in fund product development will encourage more investors interested in sustainability to get off the sidelines and invest in sustainable funds, while also enhancing the impact of these funds.