Conscious Consumer: What is Sustainable Investing? Part 1

Sustainable investing is a trending topic among financial and green business bloggers. What is it, and what is the buzz all about?

Numerous trends from global warming to the pandemic, technological advances, and social catalysts are ushering in the Age of Climate Sustainability and Stakeholder Capitalism (which takes into account the interests of customers, employees, suppliers, local communities, as well as shareholders). Gleaning lessons from transitions during the Industrial and Information Ages and embracing the United Nations Sustainable Development Goals (UN SDGs), signal that major structural changes across industries and society are needed (and evolving) to preserve the well-being of people and the planet. 

Companies and the financial system (capital markets and government) are recognizing that climate change poses both risks and opportunities for businesses and the economy, as well as the environment. This includes the devastation from increasingly common natural disasters, ongoing efforts to build resilience, and transitioning to a low-carbon economy. Looking forward, investors, lenders, insurers, regulators, and business leaders will be evaluating impacts and incorporating  the climate dimension into their business, financial, and resilience planning. Product liability suits in the tobacco and pharmaceutical industries, government regulations aimed at reducing carbon emissions from vehicles and industry, carbon credits and tax incentives to reduce greenhouse gases and promote green innovation/adoption, settlements for environmental damage from large oil spills, as well as the fallout from weak corporate governance practices, represent some of the case studies for developing a forward looking playbook. 

The Biden administration is taking bold steps toward addressing climate change, as evidenced by the US rejoining the Paris Accord (to reduce greenhouse gas emission to limit the global temperature increase) and the introduction of a $2 trillion infrastructure proposal, which includes funding for retrofitting buildings and residences, electric vehicle purchase incentives, scaling up the number of EV charging stations, and upgrades to water infrastructure. Climate savvy business leaders are now calling for even more aggressive  government  goals to cut emissions. Why not raise the bar for all the players in a given industry?

Additionally, the Department of Labor is taking a fresh look at policies that may be inhibiting access to ESG investments in retirement plans. The SEC has set up a taskforce to police public companies that fail to disclose material business risks stemming from climate change, and is exploring sustainability disclosure standards for investment products to appropriately disclose risks and to rein in “greenwashing”.

There is also increasing recognition that societal trends influence financial performance. In 2020, the pandemic highlighted public health priorities and inequities, disrupted supply chains as well as accelerated digital and e-commerce trends. The Black Lives Matter demonstrations prompted companies to voice stronger support for racial justice.  All eyes are watching to see what substantive actions will follow. Georgia’s recent passage of a law with new voting restrictions, has sparked activists (on both sides) to pressure companies headquartered in the state to speak up about the law or risk boycotts. Companies are also being pressured to help change the law. Increasingly, companies are expected to express a point of view and support the right thing, because employees and customers will want to know what the company stands for, which will ultimately impact the bottom line.  

Turning to investment considerations, a 2019 white paper from the Morgan Stanley Institute for Sustainable Investing details a study comparing sustainable funds and traditional funds from 2004 to 2018. The research showed that overall, sustainable funds provided returns in line with comparable traditional funds while reducing downside risk. 

Numerous surveys indicate that 50-75% of people, depending on age group, are interested in investments that generate a decent return (market rate or better) and help influence corporate behavior in making the world a better place. But only 10% of retail investors have invested in sustainability.  

According to a Morningstar analysis, the number of sustainable US mutual funds and exchange traded funds (ETFs) increased by 30% in 2020.  The net money flowing into those products was $51B in 2020 versus $21B in 2019, nearly a 150% increase. In 2020, US sustainable fund flows represented about 24% of the net $212B of flows into all US mutual funds and ETFs. 

These trends and data points indicate that the sustainable investing trend has begun gaining traction with mainstream investors.  Sustainable investing is available in a variety of flavors.

ESG integrated investing looks at the environmental, social, and (corporate) governance (ESG) factors that could impact financial risks such as fines, lawsuits, and reputational damage as well as positive financial impacts from transitioning to a more just and environmentally sustainable world, such as increased customer loyalty, employee retention, and business growth opportunities. It integrates the ESG factors with material influence on company financial performance together with the traditional financial factors (revenue growth, profitability, costs, capital efficiency, and risks) into the overall investment process. 

A host of index and actively managed ESG investment options are available for achieving different sustainability and investment goals, and for different risk tolerances. ESG investment managers use a range of qualitative and quantitative data for selecting investments targeting different outcomes.

Reducing harm  aims to reduce  the highest ESG risks, while striving to maintain market benchmark weights and diversification.  Typically these portfolios avoid investing in tobacco, alcohol, gambling, and weapons companies, as well as limiting (but not necessarily excluding all) exposure to businesses involved in controversial activities or carbon intensive industries.

Emphasizing progress involves “tilting” investments toward companies with lower ESG risks and that exemplify best practices regarding people and the planet.  “Tilting” levels vary by investment product,  and is a more “active” form of investing,  It generally produces portfolios that diverge from their market benchmark, thus becoming proportionately less diversified and often subject to greater investment risk.   

Thematic investing – Numerous thematic products are future trend and innovation focused, such as Clean Energy, Water, and Solar ETFs.  These products have substantial industry/sector concentration.  They may invest in a mixture of emerging and mature companies, and are frequently subject to more market volatility than more diversified funds.  

Impact/mission-based investing – ranks the non-financial impact goal equal to or higher than the financial return goal.  In addition to social themed products, this category includes direct investing in target programs/projects aligned with a specific (frequently philanthropic) mission.  

Some impact investment products are constructed around social, gender, racial justice, or faith-based  criteria.

There are also impact investments focused on affordable housing, community redevelopment, and infrastructure improvements (electrification, clean water). Green bonds are fixed income investments that fund environmentally focused initiatives and typically have slightly lower yields than conventional bonds of similar quality. 

Historically foundations, endowments, government agencies, philanthropists, and other non-profits have been the primary impact investors.  However, impact investments are increasingly available to individuals, as noted with the social themed funds, as well as through community investment programs, and charitable giving programs, such as donor advised funds.  

For a comprehensive lineup of sustainability investments and guidance on how to incorporate them into your portfolio, talk with your investment advisor about your sustainability and investment goals, risk tolerance, and time horizon. It is also important to consider diversification, management fees, valuations, and tax impacts, given your investment situation. For more sustainable investing information,  check out Morningstar’s ESG Investing website and articles.  These Morningstar articles review ESG Index Equity fund performance and provide tips for Navigating an Ocean of ESG Strategies.  Morningstar’s ESG Landscape Report can also be downloaded for a comprehensive review of money flows and performance for index and active funds for equity, bond, and blended asset classes.  A more detailed discussion of  impact investments is covered in this WSJ article.  

This article is for informational purposes and does not constitute investment or tax advice.  This information should not be relied upon as a primary basis for an investment decision. Investors should consult their tax and investment advisors for more information regarding their specific situation.