What is sustainable or ESG investing?

What is sustainable or ESG investing and does it work?

One of the most significant developments in the financial industry in recent years has been the rise of sustainable investing, also known as ESG investing. But what does it actually mean, how does it work, and does it force you to sacrifice returns?

In this video, Dan Lefkovitz from Morningstar explains sustainable investing and how it fits into a modern portfolio. Sustainable investing is best understood as a long-term approach that incorporates environmental, social and governance (ESG) criteria. It ranges from traditional exclusionary screening, such as avoiding alcohol, tobacco, gambling or coal companies, through to fully integrating ESG factors into the overall investment analysis, which is now the most popular form of sustainable investing.

You'll learn why passive investing and sustainability, which might appear to be in conflict, actually complement each other well. Because large passive managers such as BlackRock, Vanguard and State Street have to hold the companies in an index, they have become far more active as owners, engaging with those companies rather than simply selling out. You'll also discover how index funds and exchange-traded funds lend themselves naturally to the positive and negative screens sustainable investing uses, and why there is a strong alignment between younger investors, who tend to favour both sustainability and ETFs.

The video also tackles the question every investor asks: is there a price to pay for investing with your conscience? While limiting your investable universe might, in theory, constrain returns, Morningstar's data shows that in practice sustainable funds perform on par with their non-sustainable counterparts. There is even some evidence that sustainable investing can lead you toward companies poised to outperform.

The takeaway: sustainable investing has moved firmly into the mainstream. It works well alongside low-cost, passive and ETF-based strategies, and the evidence suggests you don't have to give up returns to invest in line with your values.

Chapters / Key points

• What sustainable investing (ESG) actually means
• The spectrum: from exclusionary screening to full ESG integration
• Why ESG integration is now the most popular approach
• Whether passive investing and sustainability conflict
• How big passive managers engage with the companies they own
• Why index funds and ETFs suit sustainable investing so well
• Why younger investors favour both sustainability and ETFs
• Do you sacrifice returns by investing sustainably?
• Evidence that sustainable funds perform on par, or better

Transcript

What is ESG investing and does it work?

RP: An important development in the financial industry in recent years has been the growth of sustainable investing. But what exactly does it mean? Here's Dan Lefkovitz from Morningstar.

DL: We define sustainable investing rather broadly. We consider it to be a long-term investment approach that incorporates environmental, social and governance criteria, ESG. And it can range from sort of old-fashioned, exclusionary screening, like you might've seen in an ethical or socially responsible fund. Avoiding stocks of alcohol, tobacco or gambling companies, perhaps coal. It can also be just integrating ESG factors into the overall investment analysis. And that sort of integration is actually the most popular form of sustainable investing today.

RP: Passively managed funds are very cost-effective, but, by definition, they generally invest in the whole market. So, is there a conflict between passive investing and sustainability? Dan Lefkovitz says, on the contrary, they complement each other well.

DL: It's interesting, you might think that, but in fact, we've recently seen quite the opposite. So, we've seen big passive investment managers, the likes of BlackRock, Vanguard, and State Street, become a lot more active with the companies that they own, simply because they are replicating an index. Now you are seeing passive investment managers who have to own these companies and feel like they're sort of stuck in a long-term relationship with no option for divorce, be more active when it comes to their ownership.

RP: If you want to combine passive investing with sustainable investing, there are funds available, particularly exchange-traded funds, that effectively do both.

DL: We actually think that sustainable investing lends itself very well to index funds and to exchange-traded funds. The kinds of positive and negative screens that are typically employed with sustainable investing actually fit very well in index and exchange-traded fund format. There also seems to be an alignment between the demographic that sustainability appeals to and the exchange-traded fund. Younger investors like sustainability and they also like exchange-traded funds.

RP: Of course, all investors are ultimately looking for good returns. So, is there a price to pay for investing with your conscience?

DL: The number one frequently asked question we get about sustainable investing is, "Do you sacrifice returns if you are investing sustainably?" And, interestingly, maybe in theory, if you're limiting your universe and not investing in certain companies because they're not sustainable, that would be limiting. In practice, our data show that sustainable funds perform on par with their non-sustainable counterparts. There is even some evidence to show that sustainable investing leads you to companies that are poised for outperformance.

RP: That's it. Thank you to Dan Lefkovitz from Morningstar.