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Integrating Sustainable Investing: Defining Client Goals

Investors are driven by one of two broad motivations: improving the world or improving investment results--or a blend of both.

The following article is part one of a series of excerpts from the Morningstar research report, "Integrating ESG Into Your Client's Portfolio," available to Morningstar Office and Direct clients here.

As with any other aspect of financial planning, when it comes to environmental, social, and governance investing, it is important to establish goals at the outset. Without a clear vision for an investor’s desired ESG outcomes in a portfolio, it is very difficult to determine which types and degrees of change to introduce. This difficulty is compounded by the fact that no commonly agreed upon set of terms and definitions currently exists. Morningstar is developing its own taxonomy and tools to assist advisors and investors in making these kinds of assessments. Advisors may have access to such tools from their own firms or other third-party providers. But even short of refined tools, we can set out some broader definitions as a guide.

Beginning at a broad level, we can classify investors by their level of ESG awareness by employing a framework established by academics who have worked on constructing an ESG-efficient frontier. By that rubric, investors are either ESG-unaware, ESG-aware, or ESG-motivated. The ESG-unaware investor does not have ESG considerations as even a base-level concern and thus does not take ESG data or preferences into account in investment decisions. An ESG-aware investor is mindful of ESG issues and wants to incorporate some degree of ESG data into investment decisions. An ESG-motivated investor seeks to maximize the use of ESG data to achieve an optimal trade-off between ESG scores, risk, and return.

Our next article will discuss using portfolio optimization techniques to incorporate ESG goals into specific portfolio-allocation recommendations. In the context of this introductory article, we suggest using the above labels as a simple heuristic to group investors according to their potential ESG interest levels and as a basis for next steps in the goal-setting process. Keep in mind that these categories are not necessarily static. With some degree of education, for instance, an investor might shift from ESG-unaware to ESG-aware.

Simply assigning an investor to a level of ESG awareness may be insufficient and overly broad for highly motivated ESG investors, however. While the term ESG is used in common parlance, the reality is that many investors have specific preferences concerning sustainability issues and likely place more weight on some components (environmental, social, or governance) than others; they may also have further specific thematic interests within those components. For instance, one investor may focus solely on eliminating manufacturers of guns and cigarettes from the portfolio, while another may wish to emphasize companies that facilitate sustainable environmental practices.

A further wrinkle concerns impact investing. Some investors, beyond merely eliminating funds with objectionable characteristics and favoring those with stronger ESG attributes, may wish to invest in companies seeking to actively make a positive impact on the environment or society--clean-energy firms and green bonds, for instance. Finally, we recognize that many investors will come to this process with a somewhat general desire to do something more sustainable in their investment portfolio but lack an understanding of how to focus their energies, and the advisor can play a role in identifying and then helping implement the investor's interest.

Thus, we can use another rubric to help sort investors based on a more refined set of motivations. Morningstar believes investors are driven by one of two broad motivations: improving the world or improving investment results--or a blend of both.

Investors who want to improve the world can aim to:

  • Avoid Negative Impact--Investors who want to take a "first do no harm" approach with their portfolios or wish to invest along values-based principles may choose to limit exposure to firms such as gun manufacturers or high-carbon-emissions producers. Such investors will lean more toward exclusionary strategies.
  • Seek Positive Impact--These investors want to own companies making a positive impact through their products or practices. Such investors may prefer funds geared toward producing specific outcomes or thematic funds such as those focusing on clean technology. Another option for such investors is to seek funds that pursue corporate engagement, whether through activist behavior or by exercising proxy votes.

Investors who want to improve investment results can aim to:

  • Reduce ESG Risk--Many investors believe ESG risks present long-term economic threats to companies' viability. Such investors can use Morningstar Sustainability Ratings to identify funds with lower ESG risk levels.

Of course, these categories are not mutually exclusive; many investors will exhibit overlapping tendencies. Assessing the degree of an investor’s preferences can help appropriately determine investment selection.

In the next section of this paper, we will further explore Morningstar data points that illuminate a fund's or portfolio’s various ESG attributes. An initial assessment of an investor’s ESG profile, however, will likely benefit from a detailed questionnaire or checklist, whether supplied to or created by the advisor.

Some questions to consider asking your clients include:

General ESG Awareness

  • Have you heard about sustainable investing?
  • Do you have concerns about the environment or social issues that you would like to bring to your investment portfolio?
  • Are you willing to potentially accept trade-offs in the potential returns of your portfolio in order to achieve sustainability goals? (Morningstar does not believe that evidence indicates any performance disadvantage for ESG strategies relative to non-ESG ones, but this question can nevertheless serve as a useful way to gauge an investor's level of commitment.)

Avoid Negative Impact

Are there particular concerns or values you have that would make you want to exclude certain types of companies from your portfolio? Use the list below as a guide:

  • Alcohol
  • Tobacco
  • Guns
  • Gambling
  • Fossil Fuels
  • Controversial Weapons
  • Adult Entertainment
  • Other (list)

Seek Positive Impact

  • Would you like to invest more in companies that create products and services designed to have a positive effect on the environment or society?
  • Would you prefer to reduce the carbon footprint of your portfolio?

Reduce ESG Risk

  • Are you concerned about the impact of environmental, social, or governance risks on the financial performance of companies?
  • Are you familiar with the concept of ESG material risk? If not, would you like to learn more?

A final question to consider when setting ESG goals is whether ESG should be incorporated as a portfolio objective or a portfolio constraint. Typically, investors will use risk and return as the objective functions for portfolio optimization. If we think of ESG as a third objective alongside risk and return, then an advisor could, for example, seek to maximize the portfolio’s ESG score as part of the optimization process.

This approach might work particularly well for a highly ESG-motivated investor with a relatively diffuse ESG focus. Portfolio constraints take many forms: Liquidity, sector, region, and position size are just a few common ones. Incorporating ESG as a constraint thus fits easily alongside a typical approach to constraints. Constraints could be customized for more-particular investor preferences; for instance, excluding any exposure to weapons manufacturers or establishing a maximum Carbon Risk Score for inclusion.

Thinking in terms of the above rubric, investors who fall under the Avoid Negative Impact category likely will tend to prefer exclusionary approaches to ESG investing, which operates more as a constraint. Investors who Seek Positive Impact and/or to Reduce ESG Risk will lean toward incorporating ESG goals as an objective. An additional approach for investors who prioritize reducing risk would be to incorporate ESG risk as a component of the total risk expectations for the portfolio.

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About the Authors

Josh Charlson

Director, Manager Selection
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Josh Charlson, CFA, is a director, manager selection, for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. Charlson provides fiduciary services for retirement plans and is responsible for selecting portfolio managers and mutual funds.

Previously, Charlson was a director of manager research focused on alternatives research. He was an editor of the Alternative Investments Observer, a quarterly newsletter. Charlson was also a member of Morningstar's ratings committee for alternative strategies and the stewardship committee that oversees the manager research team's assessment of fund companies.

Before assuming the role overseeing the alternatives team in 2014, Charlson was a strategist for the manager research team, covering a number of risk parity, target-date, and other fund-of-funds strategies. He oversaw Morningstar's annual target-date series research white papers as well as its quarterly target-date series reports and ratings.

Prior to Charlson's role as a strategist, he served as a hedge fund analyst for Morningstar for two years and as a senior editor for Morningstar Associates for seven years, where he focused on retirement planning and advice solutions. Charlson began his career at Morningstar as a mutual fund analyst.

Charlson holds a bachelor's degree in English from the University of Michigan, as well as a master's degree and doctorate in English from Northwestern University. He also holds the Chartered Financial Analyst® designation.

Alyssa Stankiewicz

Associate Director
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Alyssa Stankiewicz is an associate director of parent research for Morningstar Research Services LLC, a wholly owned subsidiary of Morningstar, Inc. Stankiewicz supports firm-level due diligence and is a member of the firm's US and global parent ratings committees, which oversee the assignment of Morningstar Parent Pillar ratings for all investment managers under coverage.

Before her current role at Morningstar, Stankiewicz led sustainable funds research in North America, spearheading efforts on the ESG Commitment Level and publishing reports on the sustainable funds landscape.

Before joining Morningstar in 2019, Stankiewicz completed her Master of Business Administration in sustainable innovation at the University of Vermont. She also holds bachelor's degrees in Spanish and linguistics from Earlham College.

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