What Exactly Is Sustainable Investing? – Morningstar.com

Fund investors and advisors often ask me two things about sustainable investing. One has to do with the definition: What exactly is meant by sustainable investing? The second has to do with the availability of appropriate funds: Are there enough viable choices to build a diversified sustainable portfolio? 

First, let’s talk definition. I view sustainable investing as any approach that includes environmental, social, and corporate governance, or ESG, criteria and their impact anywhere in the investment process. Sustainable investing is often equated, simply, with values-based investing, but values-based investing, in principle, is a more general concept that can describe any instance of a portfolio built to align with any set of investor values. Historically, for example, investors wanting to avoid profiting from “sin” have avoided tobacco, alcohol, and gambling stocks in their portfolios. Yet sin-stock avoidance has little to do substantively with sustainable investing, except that they are each examples of values-based investing. Sustainable investing is values-based, because at its core is the belief that publicly traded companies should be good stewards of the environment, great places to work, producers of safe and useful products, and governed with integrity and a long-term perspective. It also includes impact—the idea that investors have a role to play in encouraging the development of sustainable attributes in public companies, and the related idea that companies can be part of the solution to environmental and societal problems, which in turn can contribute to greater long-term sustainability for the overall financial system and global economy. Sustainable investing is also relevant to fixed-income, focused on investing in bond issuers with the same sustainability attributes that investors seek in companies, and, specifically, on fixed-income instruments that fund environmental and societally beneficial projects. Values-based investing, in general, makes no claim about investment performance, except perhaps by conceding some willingness to accept lower returns. One way to think about it is that values-based investors receive emotional and expressive benefits from investing in accordance with their values, and these benefits offset the slightly lower utilitarian benefit they may receive from their investment returns. By limiting the investment universe, a values-based investor risks tracking error, perhaps higher volatility, and lower returns. That said, values-based portfolios in the mutual fund world generally have performed on par with conventional funds over the past couple of decades and the use of increasingly sophisticated ways to mitigate tracking error makes me think they’ll continue to avoid relinquishing much performance. Sustainable investing makes a stronger case for investment performance than values-based investing generally. That’s because sustainable investing is not only values-based, it is also, in the words of the CFA Institute, value-driven. In other words, incorporating ESG into the investment process can be a positive driver of returns. A growing body of research, both by academics and professional asset managers, suggests that companies that are practicing the sustainable values I just described tend to be good long-term investments. That’s why so many asset managers are incorporating ESG criteria into their processes. To use one recent research example, Bank of America Merrill Lynch just issued a report showing that companies with poor sustainability performance—those scoring lower in an ESG analytical framework—were more likely to go bankrupt over a five-year horizon, more likely to experience large share-price declines, and more likely to have increased earnings volatility. Better sustainability performers were more likely to become higher-quality stocks and to have better three-year returns.I’ve been keeping track of mutual funds and exchange-traded funds that have an intentional focus on sustainable investing. I started out with funds that are tagged as “socially conscious” in the Morningstar database. This tag is applied to any fund that, by prospectus, applies any values-based criteria or theme. In searching through the prospectuses of these funds, I identified those that describe an explicit focus on sustainable investing, ESG, or related themes. Based on my criteria, I found, as of midyear, 187 open-end mutual funds and ETFs in the United States that practice sustainable investing. Of these, 141 are open-end funds and 46 are ETFs. Many of them are relatively young, with 76 not having reached their three-year anniversaries. Thirty-five funds were launched in 2016 and another dozen in the first half of 2017. Overall, these funds cover 36 different Morningstar Categories. While investors obviously can’t choose from many thousands of funds, as they can if they are looking for a standard investment, there is a sufficient number of sustainability-focused funds with good track records to build a competitive portfolio.Four out of five have Morningstar Sustainability Ratings of 4 or 5 globes, compared with only one third of funds overall that have those ratings. And of those 57 funds, 24 have Morningstar Ratings for funds of 4 or 5 stars. Out of all the sustainable funds on my list (including those with lower Sustainability Ratings and those with no rating, mostly bond funds), 42% have Morningstar Ratings of 4 or 5 stars, while only 26% have Morningstar Ratings of 1 or 2 stars. Although not a torrent by any means, investors continue to put money into sustainable funds. So far this year, the group has experienced an estimated $2.9 billion in net flows, which is on pace to top the group’s $4.8 billion in net flows for all of 2016. Parnassus funds continue to dominate net flows, as they did in 2016, with an estimated $1.7 billion in the first half of 2017, most of it going to  Parnassus Endeavor , which ranks in the top percentile of the large-growth Morningstar Category for the trailing one, three, five, and 10 years. After such a strong performance run, the fund has had a tough time finding bargains to put all its new cash to work, plus manager and firm founder Jerome Dodson is near retirement, so it currently has a Morningstar Analyst Rating of Neutral. It’s in the large-growth category’s bottom quartile for the year through June. Silver-rated  Parnassus Mid-Cap  has taken in $550 million so far this year, and its first-half return places comfortably in the top quartile of the mid-blend category. Among international equity funds, the highest net flows in the first half belonged to  Domini Impact International Equity , subadvised by Wellington Management, that also had a year-to-date return that was best in the foreign large-value category. Bronze-rated  TIAA-CREF Social Choice Bond  is taking in the most flows from the fixed-income side. Its first-half return beat the Bloomberg Barclays US Aggregate Bond Index by 0.59%. Investors can choose from 187 intentional sustainable investment open-end mutual funds and ETFs in 39 different Morningstar categories, which are on pace to garner a record amount of assets this year. Performance is fine by most standards. These funds are generally doing what they claim to be doing, based on the Morningstar Sustainability Rating, and performance is fine by most standards. As the universe of intentional sustainable investing funds continues to grow, gather assets, and perform well, it is becoming easier for investors and advisors to build portfolios around the concept of sustainability, a topic I’ll address in greater detail in future columns.