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Read This Before You Start Investing in Sustainable Funds

Understanding the basics of sustainable investing, part 1.

It's January. You're wondering whether you should start moving your money into sustainable investments. After all, in a warming planet, this is the hottest investment trend.

Before you do anything, read this piece.

Yes, sustainable investing is a major trend: Assets are flowing into sustainable funds, more and more funds are on offer, and the evidence is piling up that performance is competitive.

But there's plenty of room for misunderstanding, because sustainable investing, often called environmental, social, and governance investing, actually comprises a wide range of approaches. This gives rise to criticism about so-called "greenwashing," or fund managers making misleading claims about how sustainable their funds are.

So, before you start investing, educate yourself. Start by familiarizing yourself with the Morningstar Sustainable-Investing Framework, which will help you clear up misunderstandings--and hopefully prevent situations where you feel disappointed or even cheated when you learn that some of the sustainable funds you've purchased aren't delivering the benefits you thought they promised.

Our framework identifies six main ways that investors practice sustainable investing. They are: applying exclusions, limiting ESG risk, seeking ESG opportunities, practicing active ownership, targeting sustainability themes, or assessing impact. This piece talks about the first three.

Applying exclusions. This means funds can exclude the stocks of certain companies based on their products and services, or industries, or behaviors. For example, neither the Green Century nor the Pax World fund families, both sustainable shops, invest in fossil fuels. The $16 billion Vanguard FTSE Social Index VFTAX eschews them, too.

Limiting ESG risk. The next two approaches both refer to funds that use ESG information about companies, such as ESG ratings. In some cases, ESG metrics are used primarily to help fund managers understand how much ESG risk a company faces. For example, the $26 billion iShares ESG Aware MSCI USA ETF ESGU, which follows a popular ESG index, filters out companies involved in controversial businesses or facing severe controversies and leans toward companies with high ESG scores. Still, if you expect your fund to be fossil-fuel-free, this exchange-traded fund isn't for you. Both ExxonMobil XOM and Chevron CVX are in the portfolio, although in smaller amounts than in a traditional index ETF. Many actively managed funds, whether they are sustainability focused or traditional, also use ESG ratings to limit risk.

Seeking ESG Opportunities. This is the other side of the coin. This means using ESG information to identify companies that are sustainability leaders, by industry or sector, or to pick improving companies, or those that are using sustainability to create or enhance a competitive advantage. One actively managed specialist is $6 billion Brown Advisory Sustainable Growth BIAWX, which looks for companies with ESG-driven competitive advantages that ultimately lead to lower costs, higher revenues, or improve the value of the business. An index fund that invests in ESG leaders is $4 billion iShares ESG MSCI USA Leaders ETF SUSL.

Many sustainable funds combine all three approaches. For example, $30 billion Parnassus Core Equity PRBLX excludes companies that derive significant revenue from alcohol, tobacco, weapons, fossil fuels, nuclear power, or gambling, then employs ESG, quality, and valuation screens to filter out about 85% of the universe. From there, the fund looks for companies with durable competitive advantages, increasingly relevant products or services, exemplary management, and ethical practices.

Make no mistake, greenwashing exists. It can pose problems for the planet if money doesn't flow into solving environmental issues like climate change, or social issues like rising inequality.

But being clear on what sustainable investing is, and what it aims to achieve, can help fight that. So does being familiar with what you want to accomplish by investing sustainably.

In coming days, we'll have a look at the other three approaches we describe in our framework.

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