As the need for a global transition to a low-carbon economy becomes more apparent, the future will be about sustainable investing. This is investing that marries the traditional approach of aiming for the best risk-adjusted returns with a drive to improve corporate practices, benefit society and protect the environment.
Asset managers have already responded by launching a flurry of climate-aware funds and by tweaking existing strategies to incorporate sustainable objectives. In the past decade, more than 580 conventional funds in Europe have repurposed into sustainable-focused strategies - with 477 of these changing their name to reflect their new sustainable mandate.
What are ESG Considerations?
The hallmark acronym ESG is often used when talking about sustainable investing. Indeed, the two terms are often used interchangeably. It refers to the environmental, social and governance factors used to evaluate a company during the investment process.
Environmental factors might include how well a company reduces pollution or the carbon it emits. Social factors may include labour standards, workplace diversity, or the impact of products such as the health implications of tobacco companies or data security for big tech firms. Governance might include corporate board structure, executive pay, or prevention of bribery and corruption.
What was once considered as a niche investment area is fast gaining attention as the financial impact of ESG risks become more apparent and the long-term consequences of climate change can no longer be ignored.
Inflows reflect this; despite the market uncertainty of last year, European sustainable funds attracted inflows of €52.6 billion in the third quarter of 2020 - some 40% of overall inflows in the period. Globally, inflows into sustainable funds were up 14% in the third quarter of 2020 to $80.5 billion.
What is ESG Screening?
ESG screening is a way of mitigating risk and aligning funds with an investor’s objectives and ethical motivations. It also brings an important level of transparency and makes it easier to compare funds with their peers.
Sustainable investing requires an additional layer of data and analysis compared to traditional strategies, so screening can help investors home in on what’s really important to them and pick a fund that fits. Typically, sustainable funds can be categorised into three groups:
ESG Incorporation funds make sustainability and ESG factors a major component of their process in choosing portfolio holdings. These funds tend to use a combination of positive screening (where funds or stocks are selected based on attributes such as good corporate governance and positive environmental impact) and negative screening (where holdings are ruled out based on set criteria, such as being involved in alcohol, arms or gambling).
Impact funds can vary in focus from broad sustainability themes to specific pursuits targeting a chosen area of interest like gender equality or low-carbon emissions.
Sustainable sector funds focus on companies contributing to the transition to a green economy - industries like renewables, water, agriculture/food and green real estate.
Does ESG Screening Impact Performance?
Many investors are concerned that applying ESG screens will reduce the number of opportunities on the table and lead to weaker returns. However, there is no evidence to suggest that screening for sustainable attributes means sacrificing gains.
Morningstar recently measured the performance of sustainable open-end and exchange-traded funds (ETFs) against traditional peers in seven of the most popular Morningstar Categories. Sustainable funds have consistently shown higher survivorship rates than traditional funds - of those available to investors 10 years ago, some 72% of sustainable options are still available today, compared with just 45.9% of traditional funds. Of the surviving sustainable funds, nearly 59% have beaten their average surviving traditional counterpart.
Of course, there is still a degree of manager skill and fund quality which can affect performance, but the good news for sustainability conscious investors is that ethical concerns do not have to jeopardise performance.
Regulations are Helping ESG
Tightening regulations are helping to hold companies and funds to higher sustainability standards across the board, giving investors greater transparency and confidence in their investment decisions. In 2019 alone, there were more than 80 new or revised policy instruments relating to ESG risks.
At the core of this is the European Commission’s Sustainable Finance Action Plan. In order to meet its 2050 carbon-neutrality goal, the EU is further ramping up its sustainable finance efforts. In March 2018, it adopted a 10-point action plan on sustainable finance with an aim to channelmoney towards sustainable investment while managing financial risks stemming from ESG issues.
Other regulation helping the cause of ESG investors includes Mifid II and the EU’s Taxonomy Regulation – you can find out more about these in our EU regulation report here.
Using Morningstar Tools for ESG Screening
At a time when ESG considerations are becoming part of every investment decision, Morningstar’s data is a vital tool in any investor’s kit. Through our investment and research platform Morningstar Direct, investors can use ESG screens as well as Morningstar’s proprietary sustainability ratings to gain insights on more than 52,000 funds and 11,000 companies.
To read more about how ESG plays a role in the investment process and how Morningstar can help, download our Guide to ESG Screening here.