Interested in Sustainable Investing? 6 Questions Before You Make a Move

"How do I know if my mutual funds own companies that make X?"

"How can I get companies that make X out of my portfolio?"

Whether it's tobacco makers following the loss of a loved one to lung cancer or gun stocks after a mass shooting, many investors are motivated by traumatic events to take a closer look at what they're actually investing in. They want to ensure that their portfolios aren't out of step with their values and belief systems.

Yet that's easier said than done. While the original "socially responsible" funds used exclusion-based approaches--avoiding, say, big polluters, weapons makers, and tobacco producers--that strategy has fallen from favor. Instead, most modern environmental, social, and governance products and services are more encompassing. Rather than just dodging certain areas, sustainable investment products interpret their ESG mandates more broadly, focusing on companies that serve a broad set of stakeholders--their stockholders, of course, but communities, their employees, and the planet, as well.

In addition to encountering confusion over labeling and terminology, some investors might be constrained by where they invest; an ESG fund or ETF might simply not be an option, at least for some portion of their portfolios.

ESG strategies might also come with trade-offs: Though there are certainly affordable ESG fund options, some funds are more costly than non-ESG portfolios. There's also the issue of switching costs: Investors working through advisors might pay sales or other charges to implement a portfolio that's aligned with their values, or they could incur tax costs if they're selling appreciated positions from their taxable accounts to make way for more ESG holdings.

Before we go any further, it's worth acknowledging that some investors--including many of our stalwart Morningstar.com readers--don't concern themselves with matters of sustainability and instead invest exclusively with an eye on returns. There's no clear evidence that mutual funds employing ESG strategies lower returns relative to the broad universe of mutual funds. In fact, Morningstar's director of sustainable research, Jon Hales, says many sustainable portfolios employ such criteria because of an expected return enhancement, risk reduction, or both. But if you're happy with the portfolio you have and have no desire to incorporate ESG criteria into it, consider this your cue to stop reading.

However, if you've been considering a shift to a more ESG-friendly portfolio, here are the key questions to ask yourself.

1. What are the main issues I'd like to see incorporated into my portfolio? A good starting point when mulling a shift to a more values-aligned portfolio is thinking through what sorts of issues matter most to you. Are you primarily concerned with not investing in certain industries, such as weapons makers, major polluters, or tobacco purveyors? Or would you also like to see the companies in your portfolio taking proactive steps to be good corporate citizens and improve the world?

Morningstar's Hale notes that most investment firms have moved away from the exclusionary approach (that is, avoiding certain industries), in part because it tended to introduce huge bets relative to the market--underweighting energy firms and overweighting technology stocks, for example.

"It's a recipe for tracking error," he says. (Tracking error means that a fund has diverged from its benchmark.) You can still find such funds, which Morningstar has tagged as Socially Conscious funds, using the Premium Fund Screener on Morningstar.com, but the funds in that group employ varying approaches to screening. Some screen out investments based on the belief systems of various religions, while others are more secular in nature.

Rather than focusing just on exclusions, Hale says, most firms that manage ESG assets today "take a more comprehensive approach by incorporating ESG criteria into the overall investment process, seeking to build or tilt the portfolio toward companies that are dealing more effectively with the material sustainability issues they are facing." In short, most ESG-centered portfolios focus on companies deemed to be making a positive social and/or environmental impact.

The net effect of that shift means that investors who are motivated by a single issue--say, getting gun manufacturers out of their portfolios--may be able to do that, but most ESG funds cast their nets more broadly. While they might exclude gun manufacturers from their portfolios, they might also focus on firms that have diverse management teams, sound environmental practices, and good corporate governance, among other attributes.

2. How concerned am I with consistency? A related issue is whether you're seeking a fund that is explicitly mandated to focus on ESG issues (an "intentional" fund) or one that happens to own a lot of ESG-friendly businesses. Morningstar's Sustainability Ratings, found on the quote page for individual mutual funds, enable you to see how both intentional and nonintentional funds (that is, funds that are not managed with an eye toward ESG issues) stack up on ESG metrics. As such, the ratings are a handy way to check up on the ESG characteristics of holdings that are already in your portfolio. Premium users can also use the Premium Fund Screener to winnow down a list of prospective holdings to those that garner a high Sustainability Rating from Morningstar.

If you find that your existing holdings look fairly ESG-friendly, you may be content to stand pat. Just be aware that sustainability ratings can change over time, especially if a fund is not intentionally focused on ESG. However, maintaining a low-turnover approach can help a nonintentional ESG fund remain that way. For example, the Primecap-managed funds have tended to earn high sustainability ratings, as discussed here; because their turnover is low, they're likely to maintain those good ratings.

On the other hand, if your aim is to identify and hold funds that will consistently invest in line with an ESG charter, check whether a fund has a "Sustainability Mandate," meaning that a fund is, by charter, required to factor ESG/sustainability issues into its process. That information is found alongside the sustainability rating on the quote page for each fund. As Jon Hale notes in this article, intentional funds are much more likely to have and maintain high sustainability ratings (4 or 5 globes) than are nonintentional funds.

3. How holistic would I like to be? Speaking of consistency, how encompassing do you want to be in terms of applying ESG principles to your portfolio? Most people who are on board with the concept of sustainable investing would like to incorporate it into as much of their portfolios as possible, but there might be practical limitations. That's because until pretty recently, intentional ESG strategies have predominated in U.S. large-cap stocks; other categories, not so much. That's changing fast: Several of the new sustainable funds that came to market in 2017 were bond funds, including a passive ETF providing core intermediate-term bond exposure, NuShares ESG U.S. Aggregate Bond ETF. Small- and mid-cap ESG funds have also begun to grow in number, as discussed here. Ditto for international ESG funds. Of course, it's early days for some of these strategies, and some of these products may not be available on your preferred brokerage platform or 401(k) provider's menu.

4. Am I limited by where I can incorporate ESG strategies? Assuming you would like to be somewhat holistic in applying sustainable investment principles to your portfolio, another factor to consider is how much latitude you have to do so. If you're retired and most of your assets are in an IRA, the answer is a lot; not only do you have flexibility to populate your IRA with the investments of your choice, but you won't owe taxes to transition, either. (More on tax and other switching costs below.)

On the other hand, if your main investing vehicle is your 401(k), you're wedded to whatever investments are on offer through your plan. Even very good company retirement plans with otherwise topflight investment choices--such as the Thrift Savings Plan for government workers--may lack an ESG-friendly choice. And if your 401(k) plan does offer an ESG product, it's apt to be a U.S. large-cap fund; other categories probably won't be represented.

If you find yourself constrained by logistics, you still have options. One workaround for some 401(k) participants is a brokerage window, which enables retirement savers to select investments beyond those on the plan's preset menu. (This article discusses the pros and cons of brokerage windows.) Alternatively, you might steer any retirement assets, above and beyond the amount you need to invest to earn employer matching contributions, into an IRA, where you'll have more latitude over the investment options. At a minimum, if you've decided that you'd like to incorporate ESG principles into your portfolio but your 401(k) isn't cooperating, tell your plan administrator of your interest.

5. Have I evaluated the costs? Although sustainable investing is widely perceived to carry extra costs, that's not necessarily the case. In a landscape report released earlier this year, Hale noted that the fees associated with sustainable funds were generally in line with funds with the same share-class structure.

However, if your current portfolio consists of ultra'cheap index products, a switch to an intentional ESG portfolio will increase your outlays, at least a bit. Let's say, for example, that you currently obtain equity exposure via a total stock market index fund that charges 0.15% per year, but you were mulling a switch to Vanguard Social Index VFTSX, an ESG fund, instead; that fund charges 0.20% per year. Over a 30-year period on a $100,000, that translates into a fairly paltry cost differential, with the ESG fund costing about $1,900 more to own over that period than the non-ESG fund.

However, that gap widens out if you are employing the cheapest index funds or ETFs and/or opt for more costly ESG products can eat into returns even more, which is why it's wise to pay ultraclose attention to expenses of any products when mulling a transition to an ESG/sustainable portfolio. Assuming you've saved your portfolio in Morningstar's Portfolio Manager, you can see your asset-weighted expense ratio currently as well as your annual estimated expenses; you can then compare those figures to those of a hypothetical ESG portfolio. Focusing your attention on the growing universe of ESG index funds and ETFs is a simple way to bring the costs down.

6. Have I taken stock of the switching costs? In addition to any extra costs you'll pay for an ESG portfolio on an ongoing basis, it's also wise to consider any switching costs you'd need to pay to enact these changes. If you're using a financial advisor or paying commissions, the costs of switching to an ESG-friendly portfolio could rack up. (It depends on how you're paying your advisor for his or her services.)

Additionally, if you’re transitioning taxable holdings (i.e., non-IRA or company retirement plan assets) into an ESG portfolio, you may also pay capital gains to make changes, given that most investors’ equity portfolios have appreciated sharply over the past decade.