4 Questions You’ve Always Wanted to Ask about Sustainable Investing

What's the point of sustainable investing and more from Morningstar's Director of ESG Research.

Jon Hale 4 July, 2022 | 4:48AM
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Jon Hale

What is the real purpose of sustainable investing? Why should investors integrate ESG research and criteria?

Sustainable investing” is an umbrella term referring to investment strategies that seek competitive risk-adjusted returns alongside positive environmental, social, and governance outcomes. In so doing, it supports the transition to a more sustainable version of capitalism, which is focused on creating value for all stakeholders, rather than a focus only on shareholder primacy.

Investors integrate ESG information to give them a broader perspective on a company than they get using financial metrics alone. That provides greater insight for investment decisions. In turn, this investor focus on ESG sends a signal to companies that investors believe it is important for them to address ESG issues that are material to their business.

Other stakeholders are sending the same signal to companies. Increasingly today, customers and clients want to purchase sustainable products and services. Employees are becoming more vocal about ESG issues as well, because they want to work for companies that they believe in. In the 21st century information environment, all of these stakeholders, investors included, have more access to information about a company’s activities, impact, and public stances than ever before.

As a result, stakeholder expectations of corporations have increased. With more customers, clients, employees, and investors aligned around the concept of sustainability, no company today wants to be considered an ESG laggard. Many others aspire to be sustainability leaders because they believe they will be rewarded with greater customer loyalty, a more-dedicated and productive workforce, and diverse leadership making better decisions. Sustainability is increasingly seen as an ingredient for business success in the 21st century.

It’s not the only thing driving business success, of course, and sustainable investors typically do not base their decisions solely on ESG factors. These factors are part of an overall mosaic that informs investment decisions. But the existence of ESG metrics and the growth in the number of investors using them have already changed the way many companies operate and plan to operate going forward. That’s how using ESG in the investment process is helping drive positive outcomes not only for companies, but for people and the planet.

What's the difference between investing according to values versus using ESG criteria to mitigate risk?

The inclusion of ESG factors to inform investment decisions is focused on driving value through mitigating risks and uncovering opportunities. It also informs direct engagement (investor interactions with companies and issuers) and proxy voting to encourage companies to address material ESG issues. This approach is especially appealing to institutional investors because it is consistent with their fiduciary responsibilities.

Individual investors, by contrast, often come to sustainable investing from a values-based perspective, reflected in a desire for their investments to align with their personal values. Most people try to make decisions in their lives that are consistent with their beliefs. When they do so, they receive “expressive” benefits because their decisions express who they are as a person. And because making decisions that align with their values makes them feel good about themselves, they also receive “emotional” benefits. In the investment context, such decisions should lead to more long-term commitment to staying the course than those made purely for “utilitarian” reasons, based on returns expectations only.

There is some debate over whether value-driven ESG investing is relevant to values-based investors. I think it is. Backed by trillions in institutional assets, purely value-driven ESG investing can generate positive ESG outcomes that appeal to values-based sustainable investors, such as prodding companies to address climate risk or to improve workplace equity.

Sustainable funds themselves are a mixed bag of value-driven and values-based approaches. Many of them avoid exposure to products or industries that are objectionable to values-based investors through exclusions. Tobacco, weapons, and fossil fuel are common exclusions. Other sustainable funds pursue value-driven approaches, focusing on material ESG risks and opportunities. It’s not hard to find funds that pursue both approaches.

There is a trend towards greater personalization of individual portfolios, in which investors can pick and choose what they want to invest in subject to optimization around a targeted risk-return objective. This may work well for those purely interested in a values-based approach, but it’s harder to apply the value-driven ESG approach to personalized portfolios, and individuals are less likely to engage directly and effectively with companies than large asset managers who run funds. I think most investors interested in adding a “sustainability lens” to their investments would prefer a hybrid approach, assuming they know the full range of options available to them.

What are your thoughts about greenwashing? Is it really widespread in the sustainable investing space?

It’s an indicator of success when so many are thinking about sustainable investing and whether it lives up to its promise.

That said, greenwashing is a subjective term that I generally avoid using. I do not see it being as big of a problem as headlines may imply. I haven’t seen many instances of asset managers falsely claiming their sustainable funds are generating positive ESG outcomes, but any isolated case makes a great news story.

Many asset managers are trying to incorporate ESG considerations across all of their strategies. It’s one thing to have a firmwide capability in this area, and quite another to have all of your traditionalist portfolio managers actually using ESG information in a meaningful way. So it can be misleading for an asset manager to say it has fully incorporated ESG when it is only used in a limited way by perhaps only a few portfolio managers.

In most cases, when I hear someone use the term “greenwashing,” it is usually about a difference of opinion around whether a claim being made meets that person’s own sustainability standards. This isn’t unique to sustainable investment products. A lot of people value sustainability but define it in different ways when they make decisions about whether to choose the sustainable version of any product they may be considering.

The solution for sustainable funds is to explain their approach better and in more detail than they are accustomed to doing with standard funds. They should be answering the question, “What is THAT company doing in my sustainable portfolio?” They should be detailing the ways in which the portfolio is helping generate positive ESG outcomes; and they should be addressing whether and how they are engaging with companies on ESG issues. The SEC’s proposed rule on ESG disclosure should help. Asset managers can also use the CFA Institute’s ESG disclosure standards.

What is your take on the performance of sustainable funds so far this year?

There are two issues with the performance of many sustainable funds this year. One is the strong performance of traditional energy over the past year and a half. Not only has fossil fuel-based energy posted outsize positive gains during that period, while overall equity markets have declined, the sector has significantly outperformed renewable energy.

This has hurt many sustainable funds so far this year because most are either underweight oil and gas or avoid fossil fuels altogether. Even when recent performance is figured in, though, renewables have outperformed oil and gas in seven of the past 10 years. Renewables have declined over the past two years, but it’s an understandable correction after they posted huge gains in 2019 and 2020. Long term, I suspect most sustainable investors, and many others, see better prospects for renewable rather than traditional energy sources.

The other performance issue is that inflation has hurt growth stocks, especially across the range of internet and technology giants. Because many of these companies do relatively well on how they handle material ESG issues, they tend to be overweight in many sustainable equity fund portfolios. This has especially hindered the performance of sustainable funds in the large-cap blend Morningstar US Category. In it, the worst performers, regardless of whether they are sustainable funds or not, are those with tech overweights and oil and gas underweights.

But here’s something interesting when I looked at how US sustainable funds were doing in the large US growth stocks category: Sustainable large-growth funds are performing better relative to peers in this year’s bear market. Of the 30 such funds in the large growth category, 18 ranked in the top half through May and only one ranked in the bottom quartile.

The bottom line on the bottom line: Stay focused on why you are a sustainable investor. Your investments reflect a commitment to seek both competitive long-term returns and positive ESG outcomes. While sustainable investing includes a range of specific approaches, no sustainable fund is going to outperform all the time. The long-term thesis remains that, on balance, companies that embed sustainability into their operations, human capital, and governance will prosper more than those that don’t as we move through the first half of the century. So will companies that create actual products and services that are aligned with the transition to a more-sustainable low-carbon economy.

That’s not a guarantee of superior investment performance. Some companies will prosper despite being ESG laggards or offering unsustainable products. And for investors, valuations come into play. A sustainable fund that buys a stock when it’s undervalued and sells before it gets too pricey will outperform one that pays no attention to valuations and focuses only on holding ESG leaders or the producers of sustainable products. Also remember, individual manager skill comes into play with sustainable funds just as it does with any fund.

In the end, if you have a well-diversified portfolio, sustainable or not, and stay the course in difficult markets, it’s likely to generate competitive long-term returns for you. But having that additional sustainability connection with your portfolio should give you even more confidence to stay the course.

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About Author

Jon Hale

Jon Hale  Jon Hale, Ph.D., CFA, is the head of sustainability research for Morningstar.

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