You Don't Have to Sacrifice Returns for Sustainability
The performance of socially responsible funds has been in line with conventional funds' over time, writes Morningstar's Jon Hale.
What should performance expectations be for someone interested in sustainable/responsible funds? Do investors wanting to align their investments with their personal values, or those seeking to have an environmental or societal impact with their investments, have to settle for inferior returns? That’s a commonly believed theory—by narrowing the investment universe based on exclusionary screening of certain products or industries, sustainable/responsible investors risk underperforming market benchmarks. However, exclusionary screening is only one facet of the overall approach taken by sustainable/responsible investors today, and is an approach that’s being used less extensively than in the past.
A second facet is more positive, and definitely rising in popularity. It evaluates companies based on how well they are managing the various environmental, social, and corporate governance, or ESG, issues they face in their businesses. A growing body of research suggests that companies with better ESG performance exhibit better financial performance, particularly over the long run.1 Thus, an emphasis on corporate sustainability performance as part of a fund’s investment process might be expected to enhance its long-term performance. In addition, investors who are not particularly interested in values alignment or impact may nonetheless be interested in strategies that incorporate sustainability because of its alpha-generating potential. Our Morningstar Sustainability Rating for funds provides an assessment of the ESG performance of companies in a fund’s portfolio.
Past studies of the performance of sustainable/responsible funds have not found much evidence to support either the outperformance or underperformance theory. Instead, the gist of the research is that the performance of such funds is in line with that of conventional funds.2
For a straightforward test of the performance question, I examined the Morningstar Analyst Rating for funds, the star rating, of the funds tagged in our global database as “socially conscious,” a universe of 1,214 funds. This tag has been used in our database for 20 years to refer to funds that have a prospectus-based reference to what we now call sustainable or responsible investing. The Morningstar Analyst Rating is a relative-to-category measure of risk-adjusted return, distributed normally, from 1 to 5 stars. The results are shown in Figure 1.
Globally, funds tagged in our database as socially conscious have better star ratings than the universe as a whole. A higher percentage of funds have 4 or 5 stars (35%) than those that have 1 or 2 stars (26%). Based on the overall distribution, those percentages should be approximately the same. Fully 75% of the socially conscious funds have 3, 4 or 5 stars, rather than the two thirds that would be expected based on the normal distribution of the Morningstar Analyst Rating. In the United States, where there are relatively few socially conscious funds with star ratings—only 124 compared with 1,090 in the rest of the world—the distribution matches the overall expected distribution almost exactly (see Figure 2).
The evidence from the star rating is pretty clear: Investors interested in incorporating sustainability into their portfolios can do so without worrying about an intrinsic performance penalty. The evidence from the star rating is that socially conscious funds tend to either outperform (globally) or perform in line with (U.S.) their conventional peers on a risk-adjusted basis.
While those interested in sustainable investing should be encouraged by these results, actual fund selection remains a challenge. Any universe of funds spans a range of quality, and our group of socially conscious funds is no exception. In addition, in some markets, including the U.S., there simply aren’t that many to choose from. A U.S. investor looking for a large-value fund has about 350 choices, but one looking for a large-value fund with an intentional sustainable/responsible mandate has only nine.
The Morningstar Sustainability Rating for funds can help in two ways. First, it can help investors assess the sustainability profile of a fund’s holdings. For the most part, sustainable/responsible funds have Sustainability Ratings of High (5 globes), but if such a fund were to have a rating of 3 globes or fewer, that should raise questions. Second, the rating can be used to expand the universe of funds that might be acceptable for an investor wanting to incorporate sustainability into an overall portfolio. In the U.S. Large-Value Morningstar Category, for example, 39 funds receive a Morningstar Sustainability Rating of High (5 globes) and another 74 receive a 4-globe rating. While only five of these funds are intentional sustainable/responsible offerings, a number of them are of high quality—42 have star ratings of 4 or 5, and 19 are Morningstar Medalists.
1 Gordon Clark, et. al., “From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance,” University of Oxford and Arabesque Partners, September 2014, , and Mark Fulton, et. al., “Sustainable Investing: Establishing Long-Term Value and Performance,” DB Climate Change Advisors, June 2012.
2 Meir Statman and Denys Glushkov, “Classifying and Measuring the Performance of Socially Responsible Mutual Funds", The Journal of Portfolio Management (Winter 2016).
Jon Hale has been researching the fund industry since 1995. He is Morningstar’s director of ESG research for the Americas and a member of Morningstar's investment research department. While Morningstar typically agrees with the views Jon expresses on ESG matters, they represent his own views.