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Sustainability Matters

5 Tips for Managing Your Portfolio and Sustainability in 2023

Recommit to diversification with ESG funds and start thinking about your retirement plan.

Editor's Note
Sara Silano contributed to this story.

Whether you’re a conventional or sustainable investor, you’re sure to encounter environmental, social, and governance approaches in your portfolios. Here are five tips to keep in mind.

1. ESG funds will stay popular. That may transform your investing behavior.

Despite a disappointing year for markets, money flowed into ESG funds. Over the full year, the Morningstar US Sustainability Extended Index lost 18.09%, versus a 19.4% decline for the Morningstar US Market Index. And U.S. Google Trend query volumes for “ESG” exceeded “index fund” in 2022 and are up about 6 times the average of 2018-19, says Jessica Rabe, a strategist at DataTrek Research. Meanwhile, conventional asset managers have widely adopted ESG analysis in their investment selection process to help mitigate risk. Rabe’s takeaway: ESG “continues to gain momentum, which tells us Americans increasingly care about this theme. As such, ESG is an important investment factor to stay on top of as asset owners allocate incremental capital based on its principles.”

That could help change the dynamic for individual investors. Using ESG metrics has helped companies and investors reduce risk, but it also helps investors express their values through their portfolios. Such values engage people with their money, leading to better outcomes as people get closer to retirement, notes Bob Mann, president of Morningstar Sustainalytics. In addition, younger investors are also eager to align their investments with personal interests and values.

2. Recommit to diversifying—even if you already own a diversified sustainable fund.

That includes diversifying by style. This year showed that the big-cap growth stocks favored by many sustainable funds cratered, the energy stocks that many shunned outperformed, and value stocks glittered. As a result, the Morningstar US Sustainability Large Cap Broad Growth Index lost 30.8% in 2022, versus 10.1% for the corresponding value indexes. Meanwhile, the majority of sustainable equity funds have growth tilts, notes Morningstar’s Jon Hale. “With interest rates rising this year to cool inflation, [their] future earnings are no longer valued as highly, especially amid concerns over a slowing economy,” Hale says.

Even for broadly diversified funds, returns varied widely. Consider that over the past 12 months, the iShares ESG Aware MSCI USA ETF ESGU fell 20.3%, the SPDR S&P 500 ESG ETF EFIV fell 18.4%, and the Vanguard ESG US Stock ETF ESGV fell 23.3%. The wide dispersion of returns among these popular sustainable index funds is “a useful reminder that it’s better to allocate capital to a few ESG products rather than only one for those interested in this investment approach,” says DataTrek’s Rabe.

3. Start thinking about ESG funds in your retirement plan—and nudge your plan administrator.

Effective Jan. 30, the Department of Labor, which oversees the Employee Retirement Income Security Act of 1974, allows 401(k) retirement plans to treat sustainability as any other relevant factor, based on the fiduciary standards of prudence and loyalty, says Morningstar’s Hale. The new rule makes clear that these factors may include climate change and other ESG issues, although it doesn’t mandate including them. Some 87% of plan participants say they want their investments to be aligned with their values, 78% believe companies that are ESG-focused will have better results over time, and 74% would or might increase their overall 401(k) contribution rate if offered ESG options, according to Schroders 2022 U.S. Retirement Survey. Many plans today don’t have ESG options.

If you’re interested, now is the time to approach the retirement plan committee for your company—your colleagues who serve as fiduciaries for your plan and help choose the fund options—and ask for sustainable options. But be patient. “It takes a long time for a fiduciary board to approve new funds—to explain what those funds are, and to explain if they’re prudent,” says Aron Szapiro, head of retirement studies and public policy for Morningstar. At a minimum, “it could take six months to a year: Even among companies that want it, it will be a slow-moving ship,” Szapiro says.

4. Keep expecting Republican Party politicians to take aim at ESG, especially as the GOP will control the House of Representatives in the 118th U.S. Congress.

ESG investors have been accused of using deceptive marketing, having a secret ideological agenda, and having goals other than returns, with some of the loudest critics including aspiring presidential candidates like Florida Gov. Ron DeSantis. That’s created a political sideshow that draws attention from its real goals. “The consideration of financially material ESG risks and opportunities is a critical part of valuing a company’s stock,” says Adam Fleck, director of ESG equity research at Morningstar. It makes for tumultuous political theater—especially as regulators like the SEC push for companies to report on climate and other ESG risks.

Morningstar’s Szapiro expects the Republican-controlled House to start holding hearings on the value of ESG as early as February. What happens next? Fleck believes all the scrutiny and discussion are necessary and positive because they help sustainable investing mature and grow. “My personal view is there will be a lot of noise, very little action,” says David Sand, chief impact strategist at Community Capital Management. “I can’t imagine legislative interference in portfolio management decisions.”

5. Open your proxy ballots from companies whose shares you own upon arrival.

ESG shareholder resolutions are on the rise. They’re an important signal to management that investors care about the ESG risks to the companies they own. Jackie Cook, director of stewardship at Morningstar Sustainalytics, expects a renewed focus on executive pay in the proxy season, given the rise in the cost of living. She also expects to see climate and biodiversity figure into the proxy season, including investor requests for reports analyzing how companies with large supply chains will deal with deforestation or scope 3 emissions. Sara Mahaffy, ESG strategist at RBC Capital Markets, agrees: “We are seeing more focus on assessing the credibility of corporate climate commitments, with asset managers looking for companies to set short-, medium-, long-term, science-based climate targets, as well as companies to publish detail action and progress to back up their commitments.”

Another hot-button theme: abortion, after the U.S. Supreme Court reversed the guarantee to abortion rights in 2022. Among other things, investors will ask companies to report on risks and costs caused by state policies that severely restrict reproductive rights and how they plan to mitigate the risks. Last year, Cook reports, such proposals won significant support.

ESG Investing Is Here to Stay

ESG offers a fuller version of risk—as well as the opportunities that come with that risk. Sustainable funds can be a good place to start as you think about your portfolio in 2023.

Leslie Norton does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.