How to Choose a Sustainable Equity Portfolio

Investors are flocking to sustainable equity funds, with inflows breaking new records in 2020. But choosing a sustainable equity manager is still challenging. Here’s what investors should look for to identify portfolios that align with their responsible investing goals.

Sustainable equities are becoming increasingly popular. By the end of 2020, global assets under management for open-end sustainable equity funds reached $1 trillion, according to Morningstar. Growing awareness of environmental, social and governance issues, coupled with lessons learned during the pandemic, have added urgency to sustainable investing agendas.

But choosing a sustainable equity portfolio is perhaps harder than ever. According to Morningstar, approximately 2,300 sustainable equity funds are now available worldwide. How can investors differentiate between competing strategies and identify those most aligned with their responsibility ethos and investing goals? Start by asking the following three questions.

1. What Does Sustainability Mean to You?

Sustainability means different things to different people. For some, it’s about positively screening a benchmark for companies with certain attributes, for example, companies in which women comprise 50% of the board. Others might focus on improving environmental and social outcomes and seek a portfolio that invests in companies whose products or services contribute to such goals.

But not every sustainable portfolio clearly explains how it integrates sustainability into its investing process. Investors should look for managers with a clear and coherent definition of sustainability so they understand what they’re getting. Many investment managers follow the United Nations Sustainable Development Goals (SDGs) as a roadmap. But since these are a vast set of concepts, investors need a practical plan to translate the SDGs into actionable investment ideas. In our view, the SDGs are a set of forward-looking opportunities that can inform investment themes and help define an investment universe.

2. How Are ESG Factors Considered in the Investment Process?

ESG has become synonymous with responsible investing. But a catchy acronym doesn’t create a clear process. In our view, ESG factors should be viewed as an integral part of the value proposition for any company. Simply put, it’s impossible to value a company without considering ESG factors. From climate-change risk to diversity to good governance, ESG factors can materially influence a company’s financial outcomes and should be meaningfully incorporated in an investor’s valuation process.

Today, many investors rely on third-party ESG ratings to evaluate a company’s sustainability. But on their own, ESG ratings cannot define sustainability or serve as a true proxy for responsible investing impact, in our view. These ratings can play an important role in a sustainable investing process, but they are also flawed. For example, ESG ratings lack standard methodologies, so ratings of companies can vary dramatically between agencies. While credit ratings of issuers are about 90% correlated between providers, equity ESG ratings are less than 50% correlated between agencies. And since ESG ratings are based on publicly available information, they tend to reward companies that can meet reporting criteria—instead of best practice. That’s why a sustainable portfolio should demonstrate an independent ability to quantify ESG factors at the company level. Investors should look for sustainable managers who go beyond third-party ratings and conduct their own research to evaluate material ESG factors of investment candidates and portfolio holdings.

3. Are Engagement Initiatives Part of the Strategy?

Engagement with company management is a key tactic used by active equity managers to promote positive change. But engagement strategies differ. Some portfolio managers might think that sending an email to a company counts for engagement points, even if no reply is received. We disagree. In our view, engagement is about forming a productive partnership with management aimed at making progress in a variety of areas over the long term. That doesn’t mean getting chummy with management; rather, it’s about developing relationships that allow investors to wield influence and foster positive change, often on controversial issues, from a position of mutual respect. This type of engagement takes time, patience and multiple efforts over years. Investors need to understand that real change doesn’t happen overnight.

This type of approach can often be more effective at persuading companies to take the right steps toward a more sustainable future than taking a combative stance. We believe that playing an active role to promote positive change ultimately helps businesses deliver better results and supports long-term return potential.

These three questions are a starting point. With clear answers, investors will be able to sift through the vast sea of equity portfolios to identify clearly defined sustainable strategies with the right attributes to deliver long-term returns.