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Integrating Sustainable Investing: Strategies for Transitioning a Portfolio

Here are several approaches, with an eye toward optimizing ESG outcomes and minimizing tax consequences.

The following article is part four 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.

In considering how to transition a client's portfolio toward an environmental, social, and governance orientation, an advisor must keep several different (and sometimes competing) factors in mind, including: the investor's ESG goals and level of intensity and engagement regarding those goals; the ESG profile of the existing portfolio; the opportunity set of ESG-focused strategies within the advisor's available universe; the overall risk and return objectives of the investor; and the tax consequences of any reallocation of capital.

Going Big Versus Going Slow

An initial question is whether to move the client's portfolio as quickly and fully as possible into the target allocations. Given the behavioral and tax implications of such a drastic move, we view this scenario as having limited use cases. Nevertheless, there are several situations where the "going big" strategy may be considered:

  • Nontaxable Accounts: Situations in which a client's assets are primarily in tax-deferred retirement accounts, such as a 401(k) or IRA, may be more amenable to radical transformations, given the lack of tax consequences.
  • Younger/Newer Investors: There may be cases where younger or newer investors have a sufficiently low tax basis in their current investments to make fund changes less onerous from a tax perspective.
  • Extremely ESG-Motivated Investors: A small subset of ESG-motivated investors may be zealous enough in their ESG goals to insist on converting their portfolio to an ESG orientation as quickly as possible. Some of those investors may also intersect with wealth levels able to withstand greater immediate tax payments.

Again, these are likely to be limited situations. In any of the cases, a financial advisor must take the investor's entire financial and tax situation into close consideration and undertake a close analysis of the costs and benefits of paying early capital gains taxes on fund sales before making a recommendation.

For most investors, many of whom may be venturing into ESG investments for the first time, a more gradual approach is preferred. Here are several approaches to transitioning the portfolio, with an eye toward optimizing ESG outcomes and minimizing tax consequences.

Gradual Tactic 1: Directing New Flows

This is the most incremental of the tactics described but creates the lowest tax impact. Under this approach, an advisor would direct any new investment flows from the client toward sustainable options, while also redirecting capital gains and dividend payouts from existing funds toward the new portfolio. This could be a very gradual transition process if the client does not have substantial new assets to invest or a quicker one if the client has frequent new capital flows.

Gradual Tactic 2: Targeting Highest-Cost-Basis Funds and Harvesting Losses

For an investor willing to accept realizing some taxable gains to facilitate the transition, this tactic provides a potentially accelerated schedule. The advisor would need to evaluate the cost basis of the funds across the investor's entire portfolio, then target those with the highest cost basis for initial sales. At the same time, the advisor should take advantage of losses, when they occur, to counteract gains from the fund sales. (Many advisors already conduct some form of tax-loss harvesting for client portfolios, so adapting it to ESG portfolios would be less burdensome.) The advisor and client can plan out this implementation approach over several years to optimize the trade-off between acceptable level of taxes paid and desired speed of portfolio transformation.

Gradual Tactic 3: Targeting Highest-Impact ESG Areas

This approach, which can be complementary to others, requires the advisor to modulate between the investor's sustainability objectives, the current portfolio composition, and the possibilities in the ESG landscape. It places a priority on first transitioning assets from investments with poor ESG features to those with favorable ESG qualities. For an investor whose highest priority is reducing the carbon-emissions footprint of the portfolio, for instance, that could mean withdrawing assets from equity funds Carbon Risk Scores of High and transitioning them to funds that earn the Morningstar Low Carbon Designation. Tax considerations may not be the first concern with this tactic, but tax consequences can be lightened by reducing the amount of transactions in a given year while increasing the ESG impact of those dollars transitioned.

Gradual Tactic 4: Targeting Retirement Accounts First

This approach has the potential for a large impact more quickly, with minimal tax consequences, but it won't be tenable for all investors. To work, it requires that the investor own a significant retirement portfolio (whether an IRA, 401(k), 403(b), or other tax-advantaged retirement account), and that the advisor and client agree philosophically to view taxable and tax-deferred accounts from a holistic allocation perspective.

If those conditions are met, the transition to a sustainable portfolio can be focused first or even solely on the retirement portfolio, with no realized tax consequences. There may be limitations to keep in mind, however, in terms of the available universe. This may be less of a concern with an IRA, as they are often held at brokerages with large fund universes. For employer-sponsored retirement plans, however, the universe of ESG options is more limited. In such cases, the advisor must assess whether existing ESG options provide sufficient quality and diversification and also fit with the investor's ESG goals to warrant serving as the main ESG investments. A second option is to consider funds that are not intentional ESG funds but have favorable qualities (such as a Morningstar Sustainability Rating of High). A third option is to investigate additional funds that may be available through a plan's brokerage window.

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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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