Why Fund Managers Are Paying Attention to Climate Change--Even If You Aren't

Many asset managers today—I'd go so far as to say most of them—are paying attention to climate change. Some clearly more than others, at least judging by what they are willing to articulate to investors.

While a case could be made that this is in part a response to growing client demand—particularly from large institutional asset owners—whether you as an investor are or are not concerned about climate risks is immaterial. This is all about risk management, which is something we pay our asset managers to address.

I would be shocked to find an asset manager, large or small, who makes the claim that climate risks are not real. Even if that asset manager's portfolio managers and analysts didn't believe the scientific consensus that human-caused global warming is real, they would still need to address the obvious risks to their portfolios of, for example, carbon regulations and agreed-upon guidelines for carbon reduction emanating from the Paris Agreement.

From that perspective, it is absurd to claim that you don't want your fund manager paying any attention to climate risks. Doing so doesn't mean they will suddenly divest their fossil-fuel exposure or buy up renewable-energy and electric-car stocks. In fact, many fund managers may conclude that there are minimal material climate risks embedded in their portfolios and make few, if any, changes. The point is: They are addressing the risk, as you should expect them to do.

That said, it certainly isn't easy to assess how climate risks may affect a company, industry, or sector, nor is it easy to assess the time frame associated with those risks. There never has been an issue quite like it. Companies themselves are struggling to evaluate what kind of exposure they have to climate risks. That's why large asset managers like State Street Global Advisors and BlackRock are emphasizing to corporate boards the need to develop a capacity for overseeing climate risks, and are urging companies to focus on material climate risks in their disclosures using a framework developed by a Financial Stability Board Task Force on Climate-related Financial Disclosures.

Passive investors may be thinking they don't need to worry about any of this because they simply "own the market." But that is precisely the reason why SSGA and BlackRock are so concerned about climate risks. Because of their massive passive assets under management, they are exposed to long-term systemic risks and cannot sell individual companies for any reason short of utter financial failure.

As for the Morningstar Sustainability Rating and how it relates to all of this, the rating is a measure of how well the underlying holdings in a fund are handling the various environmental, social, and corporate governance issues facing their businesses. These are often characterized as "ESG risks," although I prefer to think of them as both risks and opportunities a business may face, which may not be picked up as clearly in traditional financial analysis. In any event, while certain elements of the environmental component of a firm's ESG rating are relevant to climate risk, such as carbon exposure, the Environmental Pillar includes other issues such as energy efficiency, waste management, natural-resource usage, and pollution. Companies involved in serious environmental controversies are penalized in the rating.

I've done a fair amount of work comparing U.S. open-end funds based on their Sustainability Ratings, and have found that higher Sustainability Ratings are associated with lower risk and higher-quality funds. In a study I did last October, U.S. large-cap funds with better Sustainability Ratings had significantly lower standard deviations and lower Morningstar Risk scores, which emphasize downside variations in returns.

Earlier this spring, I compared funds with High and Low Sustainability Ratings (5-globe funds versus 1-globe funds) across a number of categories, using the Morningstar Rating, Morningstar Analyst Rating, and the new Morningstar Global Risk Model. I found that, compared with 1-globe funds, 5-globe funds tend to have better Morningstar Ratings (risk-adjusted returns relative to category), better Analyst Ratings (forward-looking analyst evaluations), lower volatility, and greater exposure to financially healthy companies with Morningstar Economic Moat Ratings.

These findings suggest that companies that are doing better at addressing their ESG risks and opportunities tend to be quality companies, and that funds that have a lot of those types of companies in their portfolios tend to be quality funds.

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.