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Finding Sustainable Small- and Mid-Cap Funds

5-globe small- and mid-cap funds are less risky and hold stocks of larger, higher-quality companies.

When it comes to building a portfolio of sustainable funds, your small- and mid-cap allocations can be hard to fill. Only a few small- and mid-cap funds have intentional sustainable investment mandates, and, as with any handful of funds you may consider, not all of them have overall records that recommend them. Now that our Morningstar Sustainability Rating can be applied to more small- and mid-cap funds, there is a wider array of funds to consider for a sustainable funds portfolio. If you don’t find an intentional sustainable fund that is appropriate, you can use a conventional fund with a Morningstar Sustainability Rating of 5 globes, reflecting the fact that it holds stocks of companies that are stronger sustainability performers.

In addition to holding companies that are doing better at addressing sustainability issues relevant to their businesses, the typical small- or mid-cap fund with a 5-globe Morningstar Sustainability Rating, intentional or not, has certain other style characteristics. Such funds exhibit lower volatility and invest in higher-quality companies and larger companies compared with funds that score low on sustainability.

Let’s first take a look at the small- and mid-cap funds with intentional sustainability mandates. These are funds that, by prospectus, consider environmental, social, and governance, or ESG, factors in their investment process. While the specifics may vary, these funds all generally evaluate companies based on how well they are managing their ESG risks and opportunities. Most of these funds use their positions as shareholders to engage with the companies in their portfolios about sustainability issues. They have their own stylistic approaches as well. Just like conventional funds, the investment styles of intentional sustainable funds can vary, although incorporating sustainability tends to be associated with lower-risk approaches. You won’t find many deep-value, micro-cap, or aggressive-growth offerings among intentional ESG funds.

The list of intentional sustainable small- and mid-cap funds contains several promising choices. Although only a couple are under Morningstar analyst coverage, 15 have been around long enough to receive Morningstar Ratings. Twelve of those currently have Morningstar Ratings of 3, 4, or 5 stars, indicating an average-to-high range of risk-adjusted performance relative to their Morningstar Categories. Two standouts are Parnassus Mid-Cap PARMX and Pax Small Cap PXSCX. Parnassus Mid-Cap is a high-conviction, low-turnover portfolio of wide-moat mid-cap companies that have increasingly relevant products or services. Pax Small Cap is also a relatively compact portfolio of higher-quality small companies, with a disciplined buy/sell process that has kept risk in check.

Those who want to spread the net more widely can use the Morningstar Sustainability Rating to find additional funds that have portfolios of companies that perform well on ESG metrics. We award 5 globes to the top 10% of funds in each category, so several dozen funds get 5 globes in the small- and mid-cap categories in addition to the intentional sustainable funds, most of which also receive 5 globes. Five-globe funds that are also Morningstar Medalists are listed in Exhibit 2.

Small- and mid-cap funds that incorporate sustainability explicitly or have it as a characteristic of their portfolios typically invest in larger, higher-quality companies and exhibit less volatility compared with 1-globe funds. Exhibit 3 compares 5-globe small- and mid-cap funds to 1-globe small- and mid-cap funds across the 11 style factors in the Morningstar Global Risk Model. The factor exposures measure how much of an asset’s return is influenced by the factor. Exposures can be positive or negative, and a score of zero can be interpreted as average in the overall universe. The factors that differentiate 5-globe funds and 1-globe funds the most are highlighted in Exhibit 3.

Within the smaller-cap universe, 5-globe funds tend to invest in larger companies than 1-globe funds do. Smaller firms concerned with rapid growth or, for some, with simply staying in business may not have the bandwidth or the inclination to address sustainability issues and thus tend to receive lower ESG scores. Companies farther up on the growth curve, by contrast, may have more capacity to address such issues and have begun to see them as part of their broader growth strategy. Sustainability is thus related to company quality factors, such as Economic Moat, which measures the strength of a firm’s competitive advantages, and Financial Health, which measures the strength of a firm’s financial position. In addition, 5-globe funds have less Valuation Uncertainty embedded in our Quantitative Fair Value Estimate for the companies in their portfolios and less Portfolio Volatility.

It can be argued that sustainability issues aren’t as important for small- and mid-cap investing as they are for large caps. Large global companies have significant impacts on all kinds of sustainability issues. Firms that address those issues strategically can benefit financially while also helping to solve problems. Smaller firms typically don’t have big environmental impacts nor do they have large, multinational work forces and supply chains to manage. Intentional sustainable small- and mid-cap funds identify smaller firms that are nonetheless addressing sustainability issues effectively. With such funds or with many of the 5-globe funds, you are going to get lower-risk exposure to higher-quality small- and mid-cap companies but limited exposure to micro-caps.

Jon Hale has been researching the fund industry since 1995. He is Morningstar’s director of ESG research for the Americas and a member of Morningstar's investment research department. While Morningstar typically agrees with the views Jon expresses on ESG matters, they represent his own views.

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