Morningstar - Q4 2022 - S4

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within the existing sector and industry
structure and are therefore difficult to fit into
asset-allocation models.
To address the energy transition, many asset
managers claim the key is engagement with
companies rather than exclusion. I generally agree,
but when it comes to engagement, traditional
asset managers are not being transparent
enough about their engagement activities for
investors to understand whether the engagement
is making a difference. And while traditional
asset managers seem to be voting more often in
favor of ESG-related shareholder resolutions
in recent years, they do not themselves sponsor
or co-sponsor shareholder proposals.
Guidelines for Asset Managers Developing the
Next Generation of Sustainable Funds
It's important to note that sustainable investors
do have more open-end fund and ETF
choices than ever. The interest in them sends a
clear signal to companies that they should
attend to their ESG-related risks and that they
should embrace sustainability as a value-creating
principle. But how could sustainable-investing
products be improved? In the Q4 2022 issue
of Morningstar magazine, I interview three ESG
researchers who are setting standards for the
future. ( " ESG Evolves, " Page 56.)
What would Sustainable Investing 2.0 look like?
Don't stop at ESG data and ratings.
ESG metrics are important in examining the
sustainability of a given company and industry,
but they are more of a starting point than
an end point for an investment decision. Every
sustainable fund should have a clear concept
of what companies belong in its portfolio.
It should be something more than a company that
meets a minimum ESG rating threshold.
Don't ignore the broader impact of a
company's products.
Standard ESG ratings and metrics mostly address
the material ESG risks that could affect
the company financially. Funds that rely on ESG
ratings tend to ignore a company's product
impact. Impact is made easier to ignore because
impact measurements are hard to come by,
4
even though many ratings organizations are now
feverishly working on impact metrics.
Don't ignore the broader impacts of a company's
policies and behavior.
A relatively small number of about 150
companies account for 80% of corporate industrial
greenhouse gas emissions. Large retailers
can set supplier standards that have huge impacts
on thousands of companies in their supply
chain. Major employers can set pay, benefits,
and other workplace standards that are emulated
by others, such as U.S. companies announcing
this summer that they will pay for travel for
employees to obtain abortions if they live in states
where the procedure is now illegal. Many
companies funnel money to politicians, campaign
committees, and trade organizations, including
some that pursue policies the companies
themselves claim to oppose.
Don't seek out only " good " companies and
avoid " bad " ones.
Sustainability is not black and white. It is
nuanced, and public companies are on their own
journeys. They need investors encouraging
rather than discouraging their efforts. Choose
a mix of all-around sustainability leaders,
those that do well on managing their material ESG
risks but need work to improve their impact,
and those that make impactful products but need
work on how they're handling ESG issues in
their operations.
Don't ignore investment style.
Value stocks may tend to have more ESG risk
and impact issues than growth stocks, but
sustainability can still be applied to value investing,
and the wider availability of value-oriented
sustainable funds helps investors diversify in
a reasonable way.
Do have a coherent sustainability engagement policy.
Indicate what sustainability issues are going to
be raised, and why. Make clear the desired outcome
of engagements and the escalation strategy.
Explain key proxy votes.
Do explain approach to fossil fuel.
Note the extent to which the fund invests in
fossil fuel companies and the rationale for doing
so-or for excluding fossil fuel. Also explain
how the fund is addressing the transition to
renewable energy.
Do seek to be radically transparent.
Sustainable-investment strategies should make
clear what approaches or combination of
approaches to sustainable investing they use.
They should provide the sustainability-related
rationale for why each holding is in the portfolio,
including any sustainability issues it has. They
should provide examples of companies that
failed to make it into the portfolio for sustainability
reasons. Funds should produce impact reports
that include both the impacts of portfolio
holdings on people and planet, and the results of
an asset manager's own engagement and
proxy-voting activities.
Sustainable products generally are held to
higher standards by consumers. These products
are making the claim that they are better for
the world than their conventional counterparts, so
they need to make the case openly, honestly,
and convincingly. The recent wave of sustainable
funds has been reasonably successful at
gathering assets. Addressing some of these issues
in fund product development will encourage
more investors interested in sustainability to get
off the sidelines and invest-while also enhancing
the impact of these funds. K
Jon Hale, Ph.D., CFA, is a director on Morningstar's
sustainability research team.
Morningstar - Q4 2022

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