Passive And Sustainable?

Most any financial advisor, and more than a few investors, know that Morningstar rates mutual funds and exchange traded funds on a one-to five-star scale based on a portfolio’s past risk- and load-adjusted returns.

Fewer seem to be familiar with Morningstar’s new companion ratings for sustainability.

Morningstar’s new scheme evaluates how well a fund’s investments follow environmental, social and governance (“ESG”) best practices. Instead of stars, one to five globes are assigned; top-rated portfolios, i.e., those bestowed four or five globes, are heavily populated with companies that effectively manage their ESG risks and opportunities.

What, specifically, is ESG? And why bother ranking funds this way?

“ESG-based investing” is often used interchangeably with terms like “sustainable investing,” "responsible investing" and” impact investing" all of which, to one extent or another, refer to assessments of the positive environmental or social outcomes of a particular investment.

The impetus for the new taxonomy is a demographic groundswell. Morningstar cites recent surveys from U.S. Trust and Morgan Stanley showing widespread investor interest, especially among millennials and women, in companies following good corporate practices (e.g., lower greenhouse gas emissions, ethically sourced raw materials and workforce diversity, among other things).

Investors, too, are coming to believe that focusing on ESG principles can deliver superior, risk-adjusted returns over the long term. That realization hasn’t come easily. ESG, with its middle name (“social”), is often mistaken for “socially responsible investing” (SRI), an investment style characterized by chronic underperformance. The shortcoming’s largely due to the deselection of “sin stocks” (most often, tobacco, gambling and alcohol issues), securities that can contribute outsized gains to broad market benchmarks.

SRI is essentially passive. ESG investing can be more active in the sense that it seeks out those companies engaged in best practices around a host of environmental or governance concerns that should, theoretically, lead to better business performance. High-ESG-scoring companies tend to produce more reliable earnings and are exposed to less legal and regulatory risk—hence, “sustainability.”

It’s mostly the “G” (“governance”) in ESG that predicts the sustainability (not the size, necessarily) of a company’s earnings and/or dividends. Governance issues include management structure, employee relations and executive compensation, among others.

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DisclosureBrad Zigler pens's Alternative Insights newsletter. Formerly, he headed up marketing and research for the Pacific Exchange's (now NYSE Arca) ...

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