Morningstar - Q4 2022 - S3

Data Dashboard
Sustainable
Investing 2.0
After a decade of
growth, it's time
to start talking about
transformation.
Jon Hale
Sustainable investing represents a range of
investment approaches that seek to
generate competitive financial returns along with
positive outcomes for people and planet.
It's pretty basic from the demand side: More
people today want to see large corporations
treat their workers better. They want companies
to take action to limit carbon emissions and
position themselves to thrive in a low-carbon
economy. They want less plastic pollution
and deforestation. They want companies to be run
by a more diverse group of people for the
benefit of all stakeholders rather than by mostly
white men for the sole benefit of shareholders.
And so many of those who are fortunate
enough to be investors (they are also workers and
consumers and citizens) now want to be
sustainable investors. All that has led to the
runaway popularity of sustainable funds.
Why Traditionalists Are on the Defensive
Traditional investing, by which I mean the
paradigm of the past half-century or so that puts
shareholders first, is resistant to sustainable
investing and unsure how to address the demand
for it. The traditionalist response says investing
should only be about maximizing returns
at a given level of risk and that the purpose of
public companies is to generate profits for
shareholders. There is no room for normative views
on how companies should behave or on
their impact on other stakeholders and the planet.
So long as companies are operating legally,
this view goes, they should be free to maximize
profits for shareholders, and investors should
be satisfied with that. If they aren't, they
can put on their citizen hats and try to influence
policy. Or they can don their philanthropist
hats and donate to causes that address their
sustainability concerns.
The traditionalist view ignores the impact of
capital, particularly of equity ownership of public
companies. Shareholders are also owners
of companies. Today, they are starting to demand
more of the companies they own, and at
least some companies are coming to realize that
embedding sustainability concerns into their
business doesn't destroy value-it creates value.
The traditionalist view also ignores the failure
of public policy over the same time period
that the shareholder primacy model has been
dominant. During this time, corporations,
their trade organizations and lobbyists, and
superrich individuals have leveraged their
capital to successfully oppose regulation, reduce
their taxes, and defund government. The
traditional model finances problems, throws
money at policymakers to make sure they ignore
them, and then asks philanthropists to try
to counter some of the negative manifestations
of the problems out of their own pockets.
Not sustainable!
Why Many Sustainable Funds Are Missing
the Mark
So here we are, with more investors demanding
sustainable investments, but who are the suppliers
of most sustainable funds? They are the world's
largest asset managers, nearly all of which have
attained that status by being successful at
traditional investing. No wonder they struggle to
come up with investment products that truly meet
the preferences of sustainable investors.
Here are several ways that current sustainable
investment funds may miss the mark:
Reliance on ESG data and ratings.
Many sustainable funds rely on environmental,
social, and governance data to narrow their
investment universe and then proceed to pick
stocks in the way they have always done.
Because few successful, growing companies
show up as ESG laggards based on ratings,
many ESG portfolios end up looking fairly
similar to traditionalist portfolios that fish from
the same pond.
Best-in-class and tilt approaches.
Mutual funds have achieved much of their
success through diversification, which
has, unfortunately, devolved into index-hugging
for many active managers. Many ESG funds,
active and passive, rely on " best-in-class "
approaches that ensure indexlike exposure to
every sector and industry, including those that
have major ESG challenges. This leads to
anomalies like the inclusion of the " best " oil
company and tobacco company in some portfolios
and the exclusion of, in the case of the
S&P 500 ESG Index recently, a company like Tesla
TSLA because other automakers score better
on a measure of ESG that excludes product
impact. Some ESG index funds, like the popular
iShares ESG Aware exchange-traded funds,
simply take a conventional index and " tilt " it
toward companies that have better ESG scores
but do not exclude any companies at all.
Old-fashioned sin-stock exclusions.
Reflecting the views of faith-based investors
in the late 20th
century, many sustainable funds
still exclude the trio of so-called sin stocks-
alcohol, gambling, and tobacco. (A few have
recently added cannabis to their exclusions.)
While I suspect most sustainable investors have
no issue with a tobacco exclusion because it
is a product that, used as directed, kills millions
of people every year, I doubt that exclusion
of alcohol and gambling reflects the sustainability
preferences that most people have today.
Meanwhile, few sustainable funds exclude gun
retailers, private prisons, or for-profit
education providers.
Hesitancy on fossil fuel.
Because traditionalist investing has benefited
immensely from diversification in general
and fossil fuel investments in particular, asset
managers are reluctant to offer sustainable
funds that completely avoid fossil fuels.
They are also slow to commit to allocations
to renewable energy and clean tech because
these emerging industries don't fit neatly
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