Now that you’ve identified your individual priorities and dissected the sustainability of your portfolio, it’s time to start making changes.
We’ll dig into the most popular approaches to sustainable investing, and the pros and cons of each. At Morningstar, we've identified six distinct approaches: apply exclusions, limit ESG risk, seek ESG opportunities, practice active ownership, target sustainability themes, and assess impact. This section matches three of the approaches—apply exclusions, seek ESG opportunities, and assess impact—to the asset classes they best represent. The order of this section reflects the availability of each fund type, as measured by assets under management as of May 2021.
If You Want to Eliminate the Bad: Exclusionary Screening
Most, though not all, sustainable funds employ some level of exclusions in determining the investable universe. Common exclusions in the United States include gambling, alcohol, pornography, civilian weapons manufacturing, tobacco, and fossil fuels.
There are a few reasons funds may employ exclusions:
- A specific set of morals or ethics is often behind the exclusions of socially responsible, faith-based, and values-based investing strategies, such as Catholic funds or Shariah-compliant funds. These funds frequently use screens against gambling, alcohol, and pornography.
- Financial materiality means that funds employ exclusions because of the financial prospects of a sector or business category, rather than a set of morals. For example, some fund managers choose to screen out the energy sector because they expect businesses in that sector to be economically challenged in the future.
- Regulatory environments can also drive exclusions. Funds distributed in the European Union, for example, are prohibited from investing in companies that derive more than 25% of revenue from the production of civilian weapons.
These
negative screens have historically been a common argument against sustainable
investing because, by deliberately limiting the investable universe, a manager
may be limiting the fund’s potential for outperformance. But exclusions surface
in all strategy types: Even funds that don’t pursue ESG strategies exclude
companies that don’t align with their mandate or strategy. Consider that value
equity managers screen out expensive companies and growth managers exclude
slow-growing companies.
Once an exclusion is implemented, a portfolio will tilt toward one style or another. Thus, managers will take care to monitor the portfolios’ exposures to certain factors, industries, and sectors, and offset any adverse effects of the exclusion.
If You Want to Emphasize the Good: Active Equity Funds
Funds could also choose to actively bring good companies into their portfolio rather than only avoiding problematic ones. Of all asset classes, actively managed equity funds—that is, equity funds where the portfolio manager seeks to beat the overall stock market—have the most opportunities for making ESG considerations part of their investment process.
This commonly begins with a narrowing of the investable universe by screening out controversial businesses. From there, the portfolio managers select securities, typically based on a combination of financial prospects and fundamental sustainability research (both proprietary and third-party).
Then, holdings are optimized according to various objectives, including sustainability criteria. To do so, fund managers will typically allocate a greater portion of the portfolio to the most impressive securities from an ESG perspective.
If You Take a More Hands-off Approach: Passive Funds
Where active managers seek to outperform the market benchmark, passive managers use a rules-based approach that seeks to deliver returns on par with the broad market.
But the
inclusion of ESG data makes passive investing even more difficult. Unlike market-cap-weighted
stock indexes, there’s no market standard for sustainable indexes. Rather,
different index providers will have different views on ESG data.
Passive sustainable funds can also look different from one another: They can be
more like traditional index funds that tilt toward a style, market cap, or
region. Or they can resemble strategic-beta funds, which apply fundamental criteria systematically.
And
since these funds are often based on backward-looking data, they can look out
of step when the market takes abrupt twists and turns. Because of these
complications, it’s key for investors to understand how their passive holdings
fit into the broader portfolio.
If You Want to Pursue Impact Investing: Fixed-Income Funds
Sustainable fixed-income funds tend to face greater challenges than their equity peers for many reasons, but there are two main ones:
- By and large, it is more complex to develop a framework for evaluating sustainability in debt instruments than for equities because of different disclosure requirements for companies issuing debt.
- Sustainability-challenged sectors—such as energy—tend to take up larger positions in bond benchmarks than they do in most equity benchmarks. Any high-yield ESG bond fund that screened out these prominent sectors would perform quite differently from its benchmark and peers—making it hard for many advisors to recommend.
That said, there is one area where fixed-income funds hold a significant advantage over equity funds: impact investing. Unlike equity instruments, debt securities can be earmarked for specific projects and initiatives, more directly linking an investor’s capital to sustainable outcomes.
Options to invest in bonds ostensibly funding sustainable projects have increased since the European Investment Bank issued the first Climate Awareness bonds in 2007 and the World Bank followed up with its own green bond in 2008. Although some have questioned the sincerity and efficacy of these instruments, their ranks have grown considerably, including blue bonds, social bonds, and sustainability-linked bonds.
