Now that you’ve identified your individual priorities and analyzed the sustainability of your portfolio, it’s time to start making changes.
We’ll explore the most popular approaches to sustainable investing, along with the pros and cons of each. The order of this section reflects the availability of each type of fund, as measured by assets under management as of May 2021.
If you want to eliminate the bad: Exclusion screening
Most, but not all, sustainable funds use some level of exclusions to determine the investment universe. Common exclusions in the United States include gambling, alcohol, pornography, civilian weaponry, tobacco, and fossil fuels.
There are several reasons why funds may use exclusions:
- A specific set of morals or ethics is often the source of exclusions from socially responsible, faith-based and values-based investment strategies, such as Catholic funds or Sharia-compliant funds. These funds frequently use anti-gambling, alcohol and pornography screens.
- Financial materiality means that the funds employ exclusions because of the financial outlook of a sector or category of business, rather than a set of moral. For example, some fund managers choose to exclude the energy sector because they expect companies in this sector to face economic challenges in the future.
- Regulatory environments may also result in exclusions. For example, funds distributed in the European Union are prohibited from investing in companies that derive more than 25% of their income from the production of civilian weapons.
These negative filters have always been a common argument against sustainable investing because, by deliberately limiting the investment universe, a manager can limit the potential for outperformance of the fund. But exclusions appear in all types of strategies: even funds that do not pursue ESG strategies exclude companies that do not align with their mandate or strategy. Consider that value equity managers eliminate expensive companies and growth managers exclude slow growing companies.
Once an exclusion is implemented, a portfolio will lean towards one style or another. Thus, managers will be careful to monitor portfolio exposures to certain factors, industries and sectors, and to compensate for the negative effects of exclusion.
If you want to focus on the good: Active equity funds
Funds could also choose to actively include good companies in their portfolios rather than just avoiding problematic ones. Of all asset classes, actively managed equity funds – that is, equity funds where the portfolio manager seeks to beat the overall stock market – have the most opportunities for integrate ESG considerations into their investment process.
It usually starts with narrowing the investment universe by eliminating controversial companies. From there, portfolio managers select stocks, usually based on a combination of financial perspectives and fundamental sustainability research (both owner and third party).
Then, the operations are optimized according to various objectives, including sustainability criteria. To do this, fund managers will typically allocate a larger portion of the portfolio to stocks that have the most ESG performance.
If you take a more manual approach: Passive funds
When active managers seek to outperform the market benchmark, passive managers use a rules-based approach that seeks to generate returns comparable to those of the broader market.
But the inclusion of ESG data makes passive investing even more difficult. Unlike market capitalization weighted equity indices, there is no market standard for sustainable indices. On the contrary, different index providers will have different views on ESG data.
Sustainable passive funds can also look different from each other: they can look more like traditional index funds that lean towards a style, market capitalization or region. Or they can look like strategic beta funds, which consistently apply fundamental criteria.
And since these funds are often based on historical data, they can seem out of step when the market takes sharp turns. Because of these complications, it is essential that investors understand how their passive holdings fit into the larger portfolio.
If you want to continue impact investing: Fixed income funds
Sustainable bond funds tend to face greater challenges than their equity peers for many reasons, but there are two main ones:
- Overall, it is more complex to develop a framework for assessing the sustainability of debt securities than of stocks due to the different disclosure requirements for debt issuers.
- Sectors whose sustainability is threatened, such as energy, tend to take larger positions in bond indices than in most stock indices. Any high yield ESG bond fund that has eliminated these top sectors would perform very differently from its benchmark and its peers, making it difficult for many advisers to recommend.
That said, there is one area where fixed income funds hold a significant advantage over equity funds: impact investing. Unlike equity instruments, debt securities can be allocated to specific projects and initiatives, linking an investor’s capital more directly to lasting results.
The options for investing in bonds ostensibly financing sustainable projects have multiplied since the European Investment Bank issued the first climate awareness bonds in 2007 and the World Bank launched its own green bond in 2008. Although some have questioned the sincerity and effectiveness of these instruments, their ranks have grown considerably, including blue bonds, social bonds and sustainable development bonds.