Morningstar - Q3 2021 - 32

Spotlight: Integrating ESG
Step 2 Determine an appropriate asset allocation
based on these goals.
Step 3 Assess the ESG characteristics of the
client's current portfolio.
Step 4 Assess ESG options in the available
universe.
Step 5 Establish an asset migration strategy.
Here, we focus on the fund-selection piece of
the process. Think of what follows as a hands-on
guide to assessing the ESG profile of a
current portfolio and then replacing that lineup,
fund by fund, with the help of Morningstar's
proprietary ESG data. The examples we walk
through should not be thought of as prescriptive.
Rather, we intend this case study to serve
as an illustrative and flexible guide that advisors
can adapt to their clients' and their own
preferences and goals.
Incorporating ESG Goals
As with any other aspect of financial planning,
when it comes to ESG investing, it's
important to establish goals at the outset.
For this exercise, we need to make some
assumptions about the client's ESG preferences
and goals.
For the sake of this case study, we will assume
that the client is highly motivated to incorporate
sustainability into his or her portfolio but
with fairly diffuse objectives. Therefore, where
possible, we will prioritize funds targeting
an ESG mandate, as well as those with higher ESG
Commitment Levels (a qualitative assessment
by Morningstar analysts of how thoroughly
fund and asset managers incorporate ESG into
their investment processes).
We also assume that the client wishes to avoid
stocks that have a negative impact by
excluding, where possible, tobacco, controversial
weapons and small arms, and thermal coal
from the portfolio. In addition, this client wants
to minimize material risk from companies'
adverse ESG exposures, so reducing ESG risk
is a further goal. In line with this goal, we
will maximize the portfolio's overall Morningstar
Sustainability Rating, which measures
material ESG risk of the underlying holdings
in a fund.
32
Morningstar Q3 2021
Finally, this client is interested in investing in
companies that make positive contributions toward
ESG goals. While this is not a top priority, it is an
auxiliary objective.
Assessing the Non-ESG Portfolio
For simplicity and transparency, we are basing the
asset allocation for this client on the Morningstar
Moderate Lifetime Index, which uses a classic
60%/40% stock/bond mix with reasonable
diversification across subasset classes, categories,
and global regions. As a baseline benchmark,
it is easily customizable to an advisor's preferences
or client's specific objectives.
To conduct our case study, we first needed to
create a typical non-ESG portfolio. We drew
from an investment lineup used by the
Morningstar Manager Selection Services group.
This open architecture lineup uses a mix of
high-quality active and passive funds as judged
by Morningstar analysts (all are Morningstar
Medalists), but none targets an ESG mandate.
Thus, we can view the list of funds as a typical
non-ESG portfolio. Because our investment
list did not exactly match every asset class used
in the Morningstar Moderate Lifetime
benchmark, we made a few modifications to
the final allocation. The non-ESG portfolio
is shown in EXHIBIT 1 .
We'll examine the sustainability profile of
the current portfolio using a range of ESG
metrics available through Morningstar products,
including Intentional Attributes, Morningstar
Sustainability Rating, Carbon Risk, and
ESG Commitment Level. EXHIBIT 2 shows how the
portfolio rates. For the client looking to shift
assets toward managers that are mindful about
their approach to sustainability, there is
obviously massive room for improvement here.
Despite the lack of intentionality, the underlying
funds display a range of ESG risk, as captured
by the Sustainability Rating, of 2 globes (below
average) to 4 globes (above average). On a
percentage of assets basis, 25.5% of the portfolio
holds an Above Average Sustainability Rating,
which corresponds to a lower level of ESG risk,
while 24% is Below Average, which corresponds
to a higher level of ESG risk. Forty percent
of the portfolio earns no Sustainability Rating
due to the nature of the asset class and
the scarcity of available ESG data. For Carbon Risk,
only two funds earn the Morningstar Low
Carbon Designation, accounting for 12% of assets.
(The Low Carbon designation identifies funds
with the lowest aggregate levels of carbon risk
and fossil fuel exposure.)
As far as the ESG Commitment Level, only three
funds receive coverage, and those ratings
are not strong. Two index funds, Fidelity 500 Index
FXAIX and Vanguard Mid Cap Index VIMAX,
earn ESG Commitment Levels of Low. On an overall
asset manager level, Fidelity and Vanguard
receive the same Low rating. MFS Growth MFEIX
receives a Basic ESG Commitment Level, as does
MFS as an asset manager.
As we can see, there is plenty of potential in the
portfolio to improve its sustainability profile,
even with extant funds that have achieved lower
ESG Risk without intentional mandates.
Building the ESG-Aware Portfolio
To develop our ESG-aware portfolio, we combed
through Morningstar's mutual fund and
exchange-traded fund universe seeking alignment
with several criteria:
gFunds that are Morningstar Medalists under
the Morningstar Analyst Rating or Morningstar
Quantitative Rating systems.
gFunds that sit within the same Morningstar
Categories as their non-ESG counterparts.
gFunds with intentional sustainability mandates.
gFunds with Morningstar Sustainability Ratings
of Above Average or higher.
gFunds with a minimum ESG Commitment
Level of Basic or ideally higher.
gFunds that exclude controversial weapons, small
arms, thermal coal, or tobacco.
In addition, we looked for funds that, all
else equal, receive the Low Carbon designation
or pursue an active impact mandate.
We were not always able to find perfect
substitutes for funds in the non-ESG portfolio
that met all of our criteria simultaneously.
This is the result of several factors, including the
https://www.morningstar.com/funds/xnas/fxaix/quote https://www.morningstar.com/funds/xnas/fxaix/quote https://www.morningstar.com/funds/xnas/vimax/quote https://www.morningstar.com/funds/xnas/mfeix/quote https://www.morningstar.com/articles/953069/introducing-the-enhanced-morningstar-analyst-rating-for-funds https://www.morningstar.com/articles/1030233/how-to-use-the-morningstar-quantitative-rating-analysis https://www.morningstar.com/articles/1030233/how-to-use-the-morningstar-quantitative-rating-analysis https://www.morningstar.com/articles/957266/the-morningstar-sustainability-rating-explained https://www.morningstar.com/articles/1011371/new-ratings-reveal-whos-serious-about-sustainability https://www.morningstar.com/articles/1011371/new-ratings-reveal-whos-serious-about-sustainability

Morningstar - Q3 2021

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Contents
Morningstar - Q3 2021 - Cover1
Morningstar - Q3 2021 - Cover2
Morningstar - Q3 2021 - 1
Morningstar - Q3 2021 - 2
Morningstar - Q3 2021 - Contents
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