Maggie Stafford, Morningstar Research Services LLC

Sustainable investing can take many forms.

For instance, some investors seek to align their investments with their values. Others use environmental, social, and corporate governance (ESG) criteria to evaluate investment options, lower risk, or potentially enhance returns. Some seek to make environmental or societal impact alongside financial return with their investments. And still, many investors may want use each of these approaches within their portfolios.

3 approaches to evaluating portfolios with ESG factors

Sustainable investing can offer tremendous opportunity for financial advisors. Advisors can use sustainable investing solutions to help their clients identify funds that manage ESG-related risks and to enhance performance.

Here are three approaches and tools that advisors can use with clients to have more informed conversations about sustainable investing:

1. Consider aligning investments with your clients’ values: Some investors want to know what their exposure is to specific types of products, services, or business activities that they may find to be offensive or controversial. Others may want to completely exclude companies engaged in these areas based on their values or preferences. This involvement information can be difficult for advisors to obtain consistently, much less display in a meaningful way to support client conversations. To meet this growing need, we created Morningstar Portfolio Product Involvement Metrics. These holdings-based calculations use company-level research from Sustainalytics, a leading ESG research firm, to surface a portfolio's exposure to 15 areas, including alcohol, tobacco, gambling, small arms, and thermal coal. Investors can compare these exposure levels to the portfolio’s peers to help investors make decisions about their exposure levels and alternative investment options.
2. Using ESG factors to mitigate risk and potentially strengthen returns: Advisors are interested in achieving the best investment outcomes for their clients. Mitigating their exposure to risk by identifying companies with good governance and effective policies is a practical approach to implementing ESG investing. Rating systems like the Morningstar Sustainability Rating^TM can be a good starting point for many advisors to assess how a portfolio manages its ESG risks and opportunities. The rating is based on company-level ESG research from Sustainalytics. This research offers an additional layer of information beyond traditional financial metrics. It provides details about a company’s preparedness, disclosure, and performance on ESG issues relevant to their business for example: data privacy issues for a software company, or labor standards for a supply chain company. It also assesses any major incidents that have environmental or societal impact and pose risks to the company. The Sustainability Rating aggregates this information at the portfolio level. The rating and supporting metrics can be used for peer comparison, as part of a broader investment selection process, or for ongoing portfolio monitoring.
3. Investing with impact: We’ve seen a growing interest from investors who want to quantify or measure the impact of their investments. Investors may be able to achieve a more measurable impact by focusing on a specific theme such as gender diversity, clean technology, or solar power. There are impact funds that state these thematic or sector specific objectives by prospectus. And there are impact-oriented metrics that assess how any portfolio is managing the risks posed by climate change and involvement in positive environmental impact areas. We recently developed the Morningstar® Low Carbon Designation^TM for funds that incorporates both carbon risk levels and fossil fuel involvement, giving investors a way to more easily identify low-carbon funds. Within the same set of metrics, we also provide insights into involvement areas like green transportation and renewable energy for investors interested in more proactive measures that companies are taking to manage carbon risk.

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