Value(s) Investing: The Evolution of Socially Responsible Funds

In every issue of Morningstar Magazine, Undiscovered Manager profiles a manager on the Morningstar Manager Prospects list, which is compiled by Morningstar's manager research group.

Most investors wouldn't expect to find

Nevertheless, Exelon--or, to be more precise, one of its indirect subsidiaries--is a top 20 holding in the TIAA-CREF Social Choice Bond fund TSBRX. The TIAA-CREF offering owns the 6% senior secured notes of Continental Wind, which operates wind farms that provide the electricity needs of thousands of homes across the Midwest.

"We think the security will perform well over time and address the problem of climate change," portfolio manager Stephen Liberatore says.

Socially responsible investing has been around for decades. Pax World, a pioneer of responsible investing, launched its first fund in 1971. TIAA-CREF has been doing responsible investing for 40 years. The general premise is to give investors peace of mind by using screens based on moral criteria that create an acceptable universe of investment candidates. Gun manufacturers, distillers, Big Oil, and some pharmaceutical companies typically fail to pass those screens. For example, a religious-themed fund might exclude a pharmaceutical company that manufactured contraception, even if that product was just one of dozens it produced. The omissions could cause these funds to trail their benchmarks when the underrepresented sectors rally.

"It's important to understand exactly what the client is seeking in using socially responsible funds. Do they want to avoid a certain industry like fossil fuel energy producers or nuclear weapons?" says Scott Ranby, a financial advisor with Kuhn Advisors in Denver. "Clients also need to ask themselves if they are willing to sacrifice some potential gains by using these funds versus using a traditional mutual fund where the manager is free to invest where he/she sees the most opportunity."

The TIAA-CREF fund and others like it acknowledge Ranby's concern and are now putting a new spin on socially responsible investing. The fund implements an environmental, social, and governance, or ESG, strategy. There's less emphasis on traditional screens that weed out "bad" companies. Instead, this fund's process is applied at both the parent and project level to find best-in-class investments across a wide range of sectors that meet certain factors, such as strong records on human rights, the environment, or business ethics, relative to their peers. This bond fund has the added flexibility of investing across a wide array of fixed-income investments, such as corporate bonds, government securities, mortgage-backed bonds, munis, or Treasuries.

"We are finally starting to understand the opportunity set on the fixed-income side," Liberatore says. "We have the ability to invest in different parts of the capital structure that the equity investor doesn't have [access to]."

There is a growing body of research that shows investors want ESG-type investments in their portfolios. For example, research from Morgan Stanley shows 84% of millennials polled were interested in ESG investing. Gen X and baby boomers also showed strong interest. According to Morningstar research, in the U.S. there is $6.2 trillion in investments that incorporate ESG factors, and that tally is growing. (TIAA-CREF manages $17 billion across all of its ESG products, including this fund's sister offering, Bronze-rated

Popularity can also be tied to performance. While the TIAA-CREF fund's record is short, it has generated an annualized 2.8% return the past three years through October, which beats the Barclays U.S. Aggregate Bond Index by 1.2 percentage points and lands it in the top decile of Morningstar's intermediate-term bond category. Morningstar research also shows the performance of most ESG funds haven't been negatively impacted by their specialized mandates.

"This is an evolution of the concept of socially responsible investing," Liberatore says. "We have moved away from exclusionary screens to a process and a methodology to help fund the solutions we are talking about. That's where the investor base wants to go."

Sizing Up the Strategy This fund's process hinges on the analysis of both parent firms and specific projects. Liberatore and his team, in conjunction with TIAA-CREF's Responsible Investing Team, determine specific ESG criteria for their mandate and search out data providers that can apply that criteria to an investable universe of companies. For example, Liberatore and team use MSCI's socially responsible team to evaluate corporations and foreign governments. The MSCI team applies a proprietary ESG ratings process to its MSCI Investable Market Index, which comprises roughly 2,600 companies, and to dozens of foreign governments. The companies are given a grade from A through F and then ranked according to how they score across multiple factors. The top 50% within each sector and those receiving an A or B are included in the investable universe. Sustainalytics, an Amsterdam-based ESG research firm that works with Morningstar, applies a similar process to private companies, development banks, and agencies.

Liberatore is backed by considerable resources that help him pick through the list of companies--and the securities in their capital structure--derived from the MSCI and Sustainalytics teams' work. His team includes three portfolio managers, 41 research analysts, and 12 traders. The investment team looks for undervalued securities by combining a broad-based sector analysis (macroeconomic outlook, relative valuations, spread, and credit trends) with traditional fundamental credit analysis. The investment candidates derived from this work make up the bulk of the fund's portfolio.

A smaller portion of the portfolio is dedicated to what Liberatore and team call "proactive social investments." These securities, which focus on firms and specific projects and currently account for around 30% of the portfolio, are subjected to the same vetting process as other investments. These investment-grade securities generally help fund projects in any of four areas: affordable housing; community and economic development; renewable energy and climate change; and natural resources. Liberatore acknowledges the potential risks in these investments, but he believes the depth of his team allows him to spot uncovered investments with big potential before his competition.

Liberatore also leverages the considerable influence that comes from working for a company that manages almost $1 trillion of assets. For example, Liberatore says he has spent time with energy companies explaining how they can structure certain projects so that the bonds financing the deals can pass his vetting process.

"We want to change the discussion. I don't think anybody is under the impression that this is going to change overnight," he says. "But what we are hoping to see is that when we talk to an Exelon, the next time we sit down with them to discuss their long-term capital expenditure program the discussion comes up that it can build another nuclear power plant, which seems costly and time consuming, or maybe it can look at making more renewable projects."

Standing Out The fund's investment process leads to a portfolio of roughly 400-plus holdings. As of September, the bulk of the positions were corporate bonds (35%), U.S. agency securities (15%), foreign government and corporate bonds (11%), and mortgage-backed securities (11%), according to TIAA-CREF data. Top holdings as of August include bonds from Fannie Mae, San Diego Gas & Electric, Unilever, Solar Star, Intel, Kansas City Southern, and Bank of America.

Liberatore's positioning of the portfolio is largely the result of his outlook on the economy, which he believes isn't on as sound a footing as some market watchers think. Because of that outlook, he is anticipating that the Federal Reserve will raise rates, but at a moderate pace over several years. That is a key reason why he has been comfortable taking on longer duration.

The longer duration and a flatter yield-curve profile versus the benchmark helped performance the last three years. So, too, has an underweight to U.S. Treasuries and favorable corporate bond selection. The fund's 8.5% return in 2014 was tops in the intermediate-term bond category and trounced the Barclays index by 2.5 percentage points. The fund's 1.3% year-to-date gain through Nov. 30 lands it in the top 12% of that same group.

Parental Guidance TIAA-CREF has a clean regulatory record, and its fund lineup features an independent board and generally low costs. The fund's annual 0.65% expense ratio is rated Average. But expenses have been coming down as assets have increased. In addition, Liberatore has between $100,000 and $500,000 of his own money invested alongside shareholders.

While this fund's investment process and its corporate culture are sensible, its ultimate success will largely depend on both investors and corporations buying into the idea that socially responsible investing can produce solid returns for both camps.

"What our investors want is to lower the cost of capital for the projects that matter to them," Liberatore says. "But they also want to change behavior."

This article originally appeared in the December/January 2016 issue of Morningstar magazine.