End of Week Notes
The Many Approaches to Sustainable Investing
Spelling out terms and clarifying the scope of the field will produce better outcomes
This was the year that sustainable investing became truly entrenched in the investment world. Assets continued to move into sustainable funds. Asset managers continued building out their ESG capabilities. Regulators around the world implemented or are in the process of developing measures that help investors obtain relevant ESG information, understand sustainable investment products, and, in the U.S., include sustainable funds in retirement plans.
Facts on the ground support the idea that investing should take account of sustainability concerns. Global warming is worsening, prompting governments and companies to make commitments to slash greenhouse gas emissions by 50% or more this decade and to net zero by 2050. The ongoing pandemic has highlighted the importance of treating workers better, not only to benefit public health but to compete for talent at a time when employment pools have shrunk. As a new sustainability generation takes the place of older investors, the demand for sustainable investments will only continue to grow.
It’s clear that the idea of sustainable investing is attractive to a lot of investors, but what’s not so clear is the reality of doing so. This is especially true for individual investors and financial advisors. Clarity is needed around definition, terminology, and what even counts as a sustainable investment. To address that need, we have developed the Morningstar Sustainable-Investing Framework. Here are some highlights that may help you gain a better understanding of the field:
Definition
Sustainable investing consists of a set of investment approaches that seek to deliver competitive financial results, while also driving positive environmental, social, and corporate governance outcomes.
Two things to keep in mind here: First, sustainable investing is investing. It is not activism. It is about taking into account the issues and crises facing the world today that are having an impact on your investments and doing so in a conscious and systematic way that aims to improve your investments.
Second, sustainable investing considers the broader systemic impacts of investments on the world. Sustainable investors are pushing companies to make net-zero emissions commitments, and encouraging them to pay attention to material ESG issues. They are urging companies to shift to purpose-driven, stakeholder-centric business models, not to reduce profits and shareholder returns, but to help them take a more sustainable path to being a profitable business over the long term. Sustainable investors are well-aligned with other stakeholders in these pursuits. And they are providing capital that will help finance a low-carbon future.
What’s in a name?
While “sustainable investing” is the umbrella term we use in the Framework, “responsible investing”, “ESG investing”, and “impact investing” are also used, more or less interchangeably to describe the same set of investment approaches. “Responsible investing” is an older term, shortened from “socially responsible investing”, or “SRI”, which was used in the late 20th Century to describe the forerunner to today’s sustainable investing. “ESG” is easy to use, especially by investment professionals, but is jargony and better suited to describe the issues that are of concern to sustainable investors and the related metrics that have become so widely used. “Impact” is better suited to describe the part of sustainable investing that emphasizes the broader effects of investments on people and planet.
Multiple Approaches
It’s important to keep in mind that sustainable investing does not consist of a single specific investment approach; it includes a range of approaches. To think otherwise can lead to confusion and a mismatch between expectations and outcomes.
In our Framework, we have identified six sustainable-investment approaches and placed them along a continuum ranging from those that lean more toward avoiding negative outcomes, be they investment or real-world outcomes, to those that lean more toward advancing positive outcomes. Any given sustainable investment product or investor portfolio may use any of these approaches or a combination. Additionally, these approaches may be paired with a range of investment approaches (active or passive, growth or value, etc.) and applied to most asset and subasset classes.
Apply Exclusions
This approach refers to excluding sectors, companies, or practices that investors consider harmful or not in alignment with sustainability criteria.
Limit ESG Risk
Often referred to more generically as “ESG integration”, this approach uses ESG data and ratings to assess material ESG risks. While most intentional sustainable funds combine this approach with others on our list, many traditional funds have incorporated ESG information in their risk-management process.
Seek ESG Opportunities
This approach refers to the use of ESG information to identify companies that are sustainability leaders or those seeking to improve their ESG practices to build competitive advantages. It is also sometimes referred to as “ESG integration” or more specifically as “positive screening”, or “ESG best-in-class”.
Practice Active Ownership
While most asset managers practice active ownership to some degree, this approach refers to asset managers explicitly seeking positive ESG outcomes through active ownership. This may include direct engagement with companies on ESG issues, proposing ESG-related shareholder resolutions, supporting ESG issues through proxy voting, or broader efforts like being a part of ESG investor coalitions and advocating for public policy measures that address sustainability issues.
Target Sustainability Themes
By targeting sustainability themes, this approach seeks to benefit from opportunities created as the world moves towards greater sustainability and transitions to a low-carbon economy.
Assess Impact
This approach refers to investors integrating impact assessments into their investment process. Impact assessments give investors an accounting of how and to what extent an investment has generated positive societal outcomes.
If you are an individual investor or advisor, this list of approaches can help you understand, compare and contrast, sustainable-investment funds. Based on what’s in a fund’s prospectus and its other supporting materials, you can determine what approach or combination a fund uses. Most sustainable funds will use more than one approach; some may use all six. This, in turn, will help you match investor preferences with the most appropriate investments.
More broadly, if you are an individual investor, the overall Framework can help you determine whether sustainable investing is right for you and choose investments that align with your preferences. If you are an advisor, the Framework can help you convey the meaning and scope of sustainable investing to your clients, and then to construct portfolios that meet your clients’ expectations.
It’s clear that the idea of sustainable investing is attractive to a wide range of investors, but for their benefit — and for sustainable investing to reach its potential — it’s important to get on the same page when it comes to defining the meaning of sustainable investing and its scope.
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