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Great Funds, Low Carbon

Investors can find plenty of low-carbon options among our medalists.

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The new Morningstar Low Carbon Designation is given to funds that exhibit low overall carbon risk and have lower-than-average exposure to companies with fossil-fuel involvement.

Carbon risk is an assessment of how vulnerable a company is in the transition away from a fossil-fuel-intensive economy. Risks include policy and legal regulations that limit carbon emissions or put a cost on carbon emissions; public and consumer pressure on companies to align their strategies with the Paris Agreement’s 2-degree scenario; and switching costs to new green technologies. More than half of the 4,000 companies in the coverage universe of Sustainalytics, Morningstar's sustainability research partner, have exposure to carbon risk. To evaluate carbon risk at the fund level, Morningstar rolls up the Sustainalytics company carbon risk scores on an asset-weighted basis.

For a fund to receive the Low Carbon designation, it must have a Morningstar Portfolio Carbon Risk Score below 10 for the trailing 12 months and exposure to companies with fossil-fuel involvement below 7% over the same trailing 12 months. Sustainalytics sorts companies with risk scores below 10 into the Low risk category, so we are requiring the same for portfolios. The portfolio exposure threshold for fossil-fuel-involved companies was set at 7% because it represents about a one-third lower level of exposure to these companies than that of major global indexes.

Investors concerned about carbon risk can incorporate the Low Carbon designation into their selection process. To demonstrate, we used it to screen six U.S.-domiciled diversified equity Morningstar Categories (large growth, large value, large blend, foreign large blend, world large stock, and diversified emerging markets) and 10 Europe-based diversified equity Morningstar Categories (the large-growth, large-value, and large-blend categories each for Europe, U.S., and global, and diversified emerging markets). As a measure of fund quality, we also screened for Morningstar Medalists, which are funds that our analyst team has evaluated as likely to outperform their benchmark or category peers in the future.

In the United States, we found nearly 100 low-carbon medalist funds in the six categories. In Europe, investors have 64 low-carbon medalist options from which to choose in the 10 categories. However, these choices are not spread evenly across the categories because carbon risk is related to style and, especially, sector exposures. It’s easier to earn the Low Carbon designation for a fund that has less exposure to high-carbon-risk sectors and more exposure to low-carbon-risk sectors.



EXHIBIT 1 shows carbon risk scores by sector, using iShares’ global sector exchange-traded funds as proxies. The energy sector, not surprisingly, carries the greatest carbon risk, at 43.01, more than twice that of utilities, which has a score of 19.71. Materials and industrials also have higher relative scores. On the low end of the range are technology, which weighs in at 2.91, and healthcare, which has an ultralow score of 1.19.

Large Growth Full of Low Carbon
More than half of the low-carbon Morningstar Medalists in the United States and Europe are large-growth funds. Why? Because growth funds have significant investments in technology companies, which carry very little carbon risk, and tend not to invest in companies in the three sectors with the most carbon risk (energy, utilities, and materials).

Among all U.S.-domiciled large-growth funds, 79% receive the Low Carbon designation. Among the higher-quality group of large-growth medalists, 89% receive the Low Carbon designation. It’s easy to find a good low-carbon large-growth fund. In Europe, it’s the same story. Fifty-five percent of all funds in the global large-growth category receive the Low Carbon designation. Among the group of global large-growth medalists, 74% receive the Low Carbon designation. Among funds in the Europe and U.S. large-growth categories, 92% and 90%, respectively, receive the Low Carbon designation.

No So Much in Large Value
It’s significantly harder to find a good low-carbon fund on the value side. In the U.S., only 4% of large-value funds receive the Low Carbon designation. In fact, our screens turned up a grand total of two funds that are both low-carbon and a Morningstar Medalist: AMG Yacktman (YACKX) and Diamond Hill Large Cap (DHLRX). Both have Morningstar Analyst Ratings of Gold.

Large-value funds, on average, devote more than 20% of assets to companies in the higher-carbon-risk energy, utilities, and materials sectors and only about 6% to tech companies. For its part, AMG Yacktman isn’t that strict of a value fund; it has no exposure to utilities or materials and is far underweight the category in energy and overweight in tech. Diamond Hill Large Cap, on the other hand, is a more authentic value fund that is focused on companies trading at discounts to their intrinsic values. That approach has the fund underweight in energy and utilities but about equal to the category average weighting in materials and tech.

In Europe, no medalists in the Europe large-value category receive the Low Carbon designation. In the U.S. and global large-value categories, only one and three medalists, respectively, receive the Low Carbon designation. Europe large-value funds, on average, devote nearly 22% of assets to companies in the higher-carbon-risk energy, utilities, and materials sectors and only less than to tech companies. U.S. and global large-value funds, on average, are more balanced in terms of how much they allocate to higher-carbon- risk and lower-carbon-risk sectors.

To find lower-carbon options in the large-value categories, investors can use the Portfolio Carbon Risk Score rather than the Low Carbon designation and search for funds with scores in the category’s lowest quartile. This is a weaker screen than the Low Carbon designation because it doesn’t include an explicit fossil-fuel exposure component, but it is a measure of carbon risk that can be compared with other funds. Using the Carbon Risk Score turns up additional medalists in the U.S. and abroad, including Gold-rated Dodge & Cox Stock (DODGX) and Bronze-rated DNCA Value Europe.

Best of the Rest

Large Blend
In the large-blend category, just under 20% of U.S.-based funds receive the Low Carbon designation, and there are 15 low-carbon medalists, including Gold-rated Vanguard Dividend Growth (VDIGX) and Primecap Odyssey Stock (POSKX). Three medalists that have broader sustainable investing mandates also get the Low Carbon designation: Parnassus (PARNX), Parnassus Core Equity PRBLX, and Vanguard FTSE Social Index (VFTSX).

In the Europe-based global large-blend category, where 19% of funds receive the Low Carbon designation, we found 11 low-carbon medalists, including Gold-rated Dodge & Cox Worldwide Global Stock and Fundsmith Equity. In the Europe large-blend category, where 15% of funds receive the Low Carbon designation, we only found eight low-carbon medalists, including Silver-rated M&G Pan European Select and Jupiter European Opportunities. Just under 13% of funds in the U.S. large-blend category receive the Low Carbon designation. Only four are low-carbon medalists, including two Bronze-rated ETFs: UBS ETF Factor MSCI USA Quality and UBS ETF MSCI USA Select Factor Mix.

Foreign Large Blend
Just under 15% of U.S.-based funds in the foreign large-blend category receive the Low Carbon designation. Eleven medalist funds are low-carbon, including Gold-rated Artisan International Value (ARTKX) and Silver-rated T. Rowe Price Overseas Stock (TROSX). Silver-rated iShares Edge MSCI Min Vol EAFE ETF (EFAV) provides a passive option.

World Large Stock
The U.S.-based world large-stock category, where 29% of funds overall are low-carbon, also yields 11 medalist funds that receive the Low Carbon designation. Among them are Gold-rated American Funds New Perspective (ANWPX) and Dodge & Cox Global Stock (DODWX).

Diversified Emerging Markets
Few emerging-markets funds receive the Low Carbon designation. Emerging-markets managers generally must choose among companies with higher carbon risk compared with developed-markets managers. In the automobile industry, for example, emerging-markets firms have an average Carbon Risk Score of 41.2, in the High risk range, while developed-markets firms have a much lower average score of 26.3, in the Medium risk range.

In the United States, only two diversified emerging-markets medalist funds also receive the Low Carbon designation: Artisan Developing World (APDYX) and Virtus Vontobel Emerging Markets Opportunities (HIEMX); both are rated Bronze.

Overseas, only three diversified emerging-markets medalist funds also receive the Low Carbon designation. Comgest Growth Emerging Markets and Magellan are rated Gold. Vontobel Emerging Markets Equity is rated Bronze.

Again, the Portfolio Carbon Risk Score can help investors find more options. As we did for large value, search for funds with scores in the lowest quartile. That turns up nine U.S.- based medalists, including Bronze-rated JPMorgan Emerging Markets Equity (JEMSX), which now includes environmental, social, and governance criteria in its investment process. In Europe, an additional eight medalists turn up, including Silver-rated T. Rowe Price Emerging Markets Equity and Stewart Investors Global EM Leaders.

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

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.

Jon Hale does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.