How to Evaluate the "Sustainability" of Sustainable Mutual Funds

Sustainable investing has come a long way. In its early days, investment managers, like Saturna Capital, created faith-based investment processes, focused on excluding companies or industries that conflicted with the tenets of an investor’s faith. This led to proactive investing, often referred to as advocacy investing, a process that encourages companies, sectors, and regions to engage in better business practices. Along with this, investment managers are now using positive screening to identify companies that not only engage in best business practices with their broad stakeholders, but also employ robust policies in the areas of the environment, social responsibility, and corporate governance (ESG).

Sustainable investing has gained immense traction in the broader investment community. Institutional asset managers have led the pack: in April 2019, the United Nations Principles for Responsible Investment (UN PRI) reported that institutional assets now exceed $86.3 trillion among its 2,372 signatories worldwide.1 In October 2018, The Forum for Sustainable and Responsible Development (US SIF) Foundation's biennial Investing Trends report found that sustainable, responsible, and impact investing assets now account for $12.0 trillion—or one in four dollars—of the $46.6 trillion in total assets under professional management in the United States.2 This represents a 38% increase over 2016. The 2018 Trends report also found that “much of this growth is driven by asset managers, who now consider environmental, social, or corporate governance (ESG) criteria across $11.6 trillion in assets, up 44% from $8.1 trillion in 2016.”

Asset management companies have been quick to develop products to meet this growing demand. Additionally, new tools have been created to aid investment professionals in assessing a product’s sustainability. One tool is a globe rating system created by independent fund evaluation firm Morningstar. Globe ratings are part of a trademarked process that ranks a fund’s sustainability in its Morningstar-defined peer group, with five globes being the highest score, and one globe being the lowest. More recently, Morningstar has also developed a leaf rating system which identifies those funds that have the lowest carbon footprint in their peer group.

These sustainable ratings appear to influence investor behaviors. In their 2018 research paper Do Investors Value Sustainability? A Natural Experiment Examining Ranking and Fund Flows, authors Samuel M.B. Sussman suggest that funds with top ranked sustainable attributes have seen investor inflows while more poorly ranked funds have experienced outflows.3 Their research finds that mutual fund investors collectively treat sustainability as a positive fund attribute, allocating more money to funds ranked with five globes and less money to funds with a one-globe rating.

According to the authors, the dashed vertical line indicates the initial publication of Morningstar’s sustainability ratings. To the left of the line, fund flows after controlling for monthly fixed effects are accumulated over the 11 months prior to the rating publication, and to the right of the line, flows are accumulated for the 11 months post publication. The blue line represents five-globe funds, the red line one-globe funds, and the gray line funds that are rated in the middle (two to four-globe funds). Prior to the rating publication, the funds were receiving similar levels of flows. After the publication, the funds rated highest in sustainability experienced substantial inflows of roughly 4% of their fund size over the next 11 months. On the other hand, funds rated lowest in sustainability experienced outflows of about 6% of their fund size. Over the 11 months after the sustainability ratings were published, the authors estimate between $12 and $22 billion dollars in assets left one-globe funds, and between $22 and $34 billion dollars in assets entered five-globe funds as a result of the globe rating.4