For all its growth, sustainability still suffers from a number of misconceptions
Across the world, sustainability has become a hot topic in investment circles. Issues like climate change, diversity and inclusion, and corporate malfeasance have gained urgency. To help investors navigate the landscape, Morningstar launched a major initiative around Sustainable Investing in 2016. Morningstar now offers a Sustainability Rating for funds, a Low Carbon designation, and an array of datapoints around environmental, social, and governance issues.
Yet amidst the enthusiasm for sustainability lie a number of misconceptions. As we talk to investors, advisors, and institutions the world over, five myths persistent myths stand out.
1. Myth: Sustainability Is All About Excluding Things From An Investment Portfolio
Before the term “Sustainability” entered the zeitgeist, certain investment strategies in Europe and North America billed themselves as “Socially Responsible” or “Ethical.” They were defined by what was absent from their portfolios. They might have excluded “sin stocks,” companies involved with alcohol, tobacco, gambling, and adult entertainment, or avoid weapons manufacturers for humanistic reasons. Environmentalism might lead to exclusions around coal or other dirty industries, while human rights could trigger avoidance of Sudan-linked investments during the Darfur Genocide, for example, or South African companies under an Apartheid boycott.
“Exclusionary screening” is essentially about assembling a list of securities to be avoided, but otherwise conducting traditional investment analysis. It still around, but today, Sustainable Investing is about far more than just a list of “Can’t Buy” companies. Exclusions are Sustainable Investing Version 1.0.
At Morningstar, we define Sustainable Investing simply as a long-term approach that incorporates Environmental, Social, and Governance considerations as part of the investment calculus. It takes many forms. The most popular variety is what’s called “ESG Integration.” That means that in addition to income statement and balance sheet analysis, you also consider issues like water usage or carbon emissions under the Environmental pillar, product safety, workplace safety, and employee turnover under the Social pillar, board composition, and bribery and corruption practices under the Governance Pillar. This is Sustainable Investing V2.0.
Morningstar has partnered with a firm called Sustainalytics, a leading provider of company-level ESG research. Sustainalytics assigns ESG scores to more than 10,000 companies globally; their analysts evaluate companies on roughly 150 different indicators depending on the industry. For example, animal testing is germane to the pharmaceutical industry, less so automobiles. Areas of assessment include policies and programs but also ESG-related incidents. So ESG scores include both words and deeds.
2.Myth: Sustainable Investing Is All About Values
Moving from manifestation to motivation, the second myth is encapsulated in the phrase “For investors who want to align their portfolios with their values…” Sustainable investing has religious roots. Theological perspectives on the morality or money include the Church’s historical prohibition on usury or Islamic finance’s sanction on interest-bearing investments. Excluding “sin stocks” traces its origins to John Wesley, the founder of the Methodist Church, who exhorted his followers to avoid profiting at the expense of their neighbors. One of the oldest sustainable investment managers in the U.S., Pax, was founded by Methodists and focused on excluding weapons makers during the Vietnam War. Pax, of course, is Latin for “peace.”
There’s a perception in some quarters that sustainability is associated with left-wing politics. It is linked with Greenpeace-affiliated environmentalists or the Occupy Movement opposing the 1%.
There’s no denying that there are values at play within sustainable investing. Some of the world’s biggest sustainable investors—think the Swedish Church—might be mission-based. Or, they may simply want to avoid investing in a manner offensive to its members. The California Teachers Retirement System or Dutch pension funds come to mind.
But many investors think about sustainability as an enhancement to the investment process—a risk mitigator, or even a route to superior returns. “Materiality” has become a buzzword, as environmental, social, and governance issues are seen as having a real impact on companies’ financial results.
The list of companies that have experienced ESG-related disasters include names like Enron, BP, Volkswagen, Toshiba, ICICI Bank, and Facebook. Sustainability assessments did not flag each and every one of these cases ahead of time. But it did predict some. ESG research identified health and safety concerns at BP ahead of the Deepwater Horizon oil spill. Sustainable investors surfaced user privacy issues at Facebook before they led to a “blow up,” with major financial implications.
Common sense dictates that climate change is a real risk that companies need to consider. Diversity is not just a social good but can lead to diversity of perspectives and better decision-making. Labor standards within a company’s supply chain can become legal, regulatory, or reputational issues. These days, when so much corporate value is represented by “intangible assets,” brand damage can be devastating.
3. Myth: Sustainability Is A Luxury That Only Rich Countries Need To Worry About
Many hold the view that Western economies, when they were at earlier stages of development, polluted, exploited their workers, and greased the wheels with unethical business practices. Now that they’re rich and comfortable, they’ve grown a conscience. How hypocritical for them to enforce their current beliefs on countries still clawing their way up the development curve.
When we apply Sustainalytics’ company-level ESG assessments to Morningstar’s family of 46 country indexes, an interesting picture emerges.
Yes, Europe is clearly the world’s leading region for corporate sustainability. But Japan posts only a middling score, largely due to governance issues. The U.S. score trails those of Brazil and India, dragged down by Facebook, Amazon.com, Apple and Google, none of which score particularly well on ESG criteria. India’s score is harmed by companies like Bank of India, ICICI, and PNB, but boosted by Infosys, L&T, and Tata Consultancy Services.
Meanwhile, pockets of strength emerge in the emerging world. Taiwan, South Africa, Colombia, and Central Europe all score highly. Taiwan Semiconductor is a global leader within the semiconductor space. South Africa is a narrow market dominated by Naspers, which has a strong ESG score. The financial services companies that dominate the Colombian stock market are global leaders on sustainability.
The emerging world’s sustainability leaders know that sustainability is good business practice. Using less energy doesn’t just benefit the earth, it also saves money. Treating workers well is a way to attract and retain talent—critical in the knowledge economy. An independent board of directors provides an important check on corporate managers, leading to better decision making.
4. Sustainable Investing Gets A Lot Of Attention But Few Assets
It’s true that sustainable investing was historically more of an institutional phenomenon. Pension funds, sovereign wealth funds, endowments and the like represent the bulk of sustainable assets globally.
But ESG-screened investments are becoming increasingly popular on the retail level. According to Morningstar’s numbers, assets in European mutual funds and exchange-traded funds incorporating sustainability criteria are approaching EUR 750 billion. Those assets are mostly in actively managed funds, but index tracking passives are gaining market share. Flows into sustainable funds during 2018 were strong enough to compensate for down markets.
In the U.S. market, ESG funds have put together several years of strong inflows. From 2013-2018, annual net flows into sustainable funds averaged $4.4 billion. Exchange-traded funds using ESG screens hold similar assets to traditional mutual funds.
The trend is highly likely to continue. All the studies show that women and younger investors are keener on sustainability than older males. As wealth transfers to women, who tend to outlive their husbands, and across generations, more assets will flow into ESG-focused strategies. Advisors who ignore this trend will lose clients.
5.Myth: Sustainable Investing Requires A Return Sacrifice
Surely, one of the factors impeding heavier asset flows into ESG-screened investments relates to the final myth around the underperformance of sustainability. In theory, any limiting of an investor’s opportunity set could have negative consequences. But in practice, sustainable investments have performed well.
Morningstar has looked at this several different ways. We have surveyed the academic literature, concluding that exclusionary investing introduces no performance penalty and that companies that score well on ESG could actually outperform their peers. We have looked at the historical performance of funds that label themselves as sustainable and find that their returns are a bit higher than average. We have also found that funds with a higher Morningstar Sustainability Rating also tend to have a higher Morningstar Rating, which compares a fund’s risk and return to category peers.
A recent study of Morningstar’s 56 unique indexes that incorporate ESG screens finds that nearly three quarters have outperformed since their inception. These include broad sustainability indexes, a Low Carbon series, and those that focus on diversity and inclusion.
Performance will wax and wane over time. What’s more interesting is the persistent relationship we’ve observed between Sustainability and some other factors correlated with long-term investor success. Morningstar has observed that companies that score well on ESG criteria also tend to be more profitable, financially healthier, and less volatile than their peers. This is true across funds and indexes, and in various geographies.
This conclusion supports the view that sustainability is material. Across the globe, sustainability is increasingly about both values and value.