Sustainability as a Megatrend

Readers of a certain age may remember John Naisbitt's 1982 book, Megatrends, which described the major social, economic, political, and technological developments that Naisbitt argued would shape the future. It was a popular book that was both assigned reading in college courses and available in supermarket checkout lines. The idea has stuck with me over the years. Megatrends are trends that are likely to have broad, deep, and long-lasting impacts on our lives and institutions, and those of future generations.

The concept comes to mind when I think about sustainability and its impact. Sustainability emphasizes the need to think in more holistic and long-term ways to make decisions that meet our needs in the present without diminishing the ability of future generations to make decisions that meet their needs. It emphasizes the interconnection between financial, natural, and human capital. Says Yale professor Daniel C. Esty, the faculty director of the Yale Sustainability Leadership Forum:

“Sustainability is going to be an organizing concept of the 21st century—one of the big-picture ideas that frames how all aspects of life, in business, in public affairs, in academic settings, are thought about.”

Sustainability is already having a big impact on business. Globalization forces companies to oversee supply chains in a responsible way and operate in areas with scarce natural resources, which must be used responsibly and efficiently.

The intense competition for the best talent across many industries means companies must treat their workers well, not only in terms of better pay but also in terms of workplace safety, nondiscrimination and diversity policies, and the need to develop and maintain a positive corporate culture and sense of purpose.

Global warming requires attention to reducing carbon emissions in both operations and product usage, as well as to evaluating the range of possible physical impacts on a company’s markets and customers, the locations of its offices and factories, and its use of natural resources. Companies face growing consumer demand for sustainable products and processes. Between this demand and operational efficiencies, more companies are recognizing that sustainable products and services can be profitable.

Sustainability as a megatrend also explains the growth of sustainable investing. As more companies take sustainability into account in their decision-making, investors must also consider sustainability in theirs. The systematic consideration of environmental, social, and corporate governance, or ESG, factors within the investment process is how investors are doing that.

But that straightforward-sounding definition belies a variety of approaches being taken to sustainable investing. Keep in mind that although a small number of investors have been concerned about what we now call sustainability since the 1990s, it has only been in the past decade or so that ESG investing has developed as a concept and that company-level ESG data has become sufficiently robust to be used in a sophisticated way by investors.

In just the past few years, it seems, we have reached a tipping point. A recent survey of asset managers conducted by Harvard Business School professors showed that more than 80% now consider ESG when making investment decisions.

One big misconception is that asset managers are paying attention to ESG simply because of growing client demand. But in the same survey, more than three fourths of asset managers who said they now consider ESG information when making investment decisions indicated they were doing so because they believe “ESG information is material to investment performance.”

How is this all playing out for investors? Many more strategies have become informed by ESG analysis. Here are four broad approaches, reflecting different levels of ESG commitment:

1 ESG Aware In ESG-aware strategies, asset managers make ESG data and analytics available to their analysts and portfolio managers, but how the latter use the information is up to them. Managers use the information to varying degrees in their investment process. ESG is not mandated by the prospectus (or stated investment objective, in the case of separately managed accounts).

Wellington Management, for example, considers ESG criteria “as one set of factors among many that should be weighed appropriately to inform investment decision-making.” Jensen Investments, recognizing a connection between ESG and the firm’s focus on quality companies, says that ESG factors are integrated “to the extent that our team believes they may impact a company’s fundamentals and ultimately its ability to generate sustainably high returns on capital.”

As more asset managers make ESG data and analytics available to their firms and as analyst teams use it to inform their work, the number of ESG-aware strategies will continue to increase.

2 ESG Incorporation Similar to ESG aware, an ESG-incorporation strategy considers ESG as necessary for a more complete investment analysis but it's just one set of criteria among many that may be relevant to an investment decision. An ESG-incorporation strategy goes a step further by explicitly including ESG criteria as part of its investment process.

This higher level of commitment to ESG is reflected in a strategy’s fund prospectus or statement of investment objectives. It means that the asset manager has formalized the use of ESG and its role in the process for a specific strategy and that an asset manager could defend its ESG commitment in the event of a regulatory audit.

The holdings of such strategies are not necessarily companies with the strongest ESG profiles, but those for which ESG considerations have not been disqualifying.

A number of mutual funds have adopted this approach over just the past two years, including offerings from J.P. Morgan, Morgan Stanley, RBC, Schroders, and TCW. Earlier this year, Aberdeen added this statement to the prospectuses of all 19 of its funds available to U.S. investors:

“ESG analysis is fully integrated into investment decisions for all equity holdings. As such, the Advisor evaluates ESG factors as part of the investment process and this forms an integral component of the Advisor’s quality rating for all companies.”

This trend will likely continue as more ESG-aware asset managers formalize their use of ESG criteria and become more comfortable with placing them in their prospectuses. This level of commitment makes a strategy attractive to more-committed ESG investors, particularly those whose primary interest in ESG is financial performance.

3 ESG Outcome A strategy seeking an ESG outcome is one in which ESG considerations play a bigger role in the investment process, resulting in a portfolio of companies with better sustainability profiles. The typical ESG-outcome portfolio is tilted toward such companies and generally excludes or underweights companies with poor sustainability profiles.

One common approach is to select best-in-class companies by sector. Many ESG-outcome funds are passive, based on ESG indexes that are themselves derived from a conventional parent index. Some have many holdings, like the Vanguard FTSE Social Index Fund VFTSX, which has 450 positions. Others are more concentrated, such as iShares MSCI USA ESG Select ETF SUSA, which has around 100 positions.

ESG-outcome funds can also be actively managed and may include traditional financial criteria. It isn’t uncommon for these funds to use some of the traditional exclusionary screens (such as tobacco and guns). Most of these funds use key terms like “ESG” or “sustainable” in their names.

4 ESG Impact An ESG-impact strategy is similar to an ESG-outcome strategy, but in addition to its focus on financial outcomes, it also attempts to deliver a positive societal or environmental impact. The portfolios of impact strategies may look like those of ESG-outcome strategies, but they also include "active ownership" activities, such as ongoing engagement with companies about ESG issues and a willingness to sponsor and vote in favor of ESG-related shareholder resolutions.

Increasingly, impact portfolios are taking the additional step of measuring and reporting their impact to investors. Some of these strategies are focused on specific themes, such as low carbon or gender equity, while others are using the 17 U.N. Sustainable Development Goals as a framework for evaluating a company’s impact and that of the portfolio overall. While some impact strategies downplay ESG evaluation in security selection in favor of impact criteria, they are generally the most comprehensive of sustainable strategies. Also, while more are using the term “impact” in their names, many of these strategies use “ESG” or “sustainable,” making it hard to distinguish them from ESG-outcome strategies.

Work in Progress Sustainable investing is clearly still a work in progress. As ESG becomes a more common element of most asset managers' investment process, the number of ESG-aware and ESG-incorporation strategies will keep growing, and more investors will have ESG integrated into their portfolios. Including sustainability evaluations will just become part of what it means to invest. For those who want to achieve impact alongside financial return with their investments, the number of ESG-impact strategies will continue to grow. More asset managers are broadly considering sustainability in their investment decisions, and investors now have a range of approaches available.

This article originally appeared in the October/November 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.

Learn more about Morningstar’s approach to sustainable investing, or check out a curated collection of our latest ESG content.

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.