The number of actively managed funds that are adding environmental, social, and governance criteria to their prospectuses is exploding. I first noticed this phenomenon two years ago when several funds run by J.P. Morgan, Morgan Stanley, and RBC did so. Then last year, another 51 funds added ESG criteria to their prospectuses, including all 21 funds run by Aberdeen.
But in this year's first quarter alone, an astounding 73 funds added ESG criteria. Most of these are equity funds, spanning US, international developed, and emerging markets. Some are bond funds. Twenty-three of the funds have more than $1 billion in assets.
More asset managers are recognising that incorporating the consideration of ESG factors is just common sense given the material sustainability challenges many companies face today. This view has become increasingly mainstream, as illustrated by the CFA Institute's recently released position statement on ESG: "The CFA Institute encourages all investment professionals to consider ESG factors, where relevant, as an important part of the analytical and investment decision-making process, regardless of investment style, asset class, or investment approach." Moreover, the CFA Institute's view is that factoring ESG into the investment process "is consistent with a manager's fiduciary duty to consider all relevant information and material risks in investment analysis and decision-making."
Adding a line in the prospectus about ESG incorporation does not fundamentally change these funds' overall investment processes. But it does formally convey to investors that the funds are using ESG to inform their investment decisions. For most of these funds, which I call “ESG consideration funds”, ESG criteria may or may not play a role in the selection of any specific security, and ESG considerations generally do not come into play at the portfolio-construction stage. These funds typically do not use exclusionary screens, impact analysis, or shareholder engagement as a formal part of their process. They are best thought of simply as funds that consider ESG information to be relevant to a thorough investment process.
Expanding Universe for Investors
Having more funds recognise the relevance of ESG is, of course, a good thing for investors who, after all, are paying their fund managers to bring to bear all material, relevant information in making investment decisions. Having more funds formally acknowledge a role for ESG in their prospectuses helps advisers and fund investors understand and identify those managers that are doing so. Investors for whom ESG consideration is a basis for fund selection have an expanding universe from which to choose.
On the other hand, simply adding a line in a prospectus about ESG consideration doesn't necessarily reflect a real commitment to sustainable investing or a significant change in a fund's investment process. And though these funds are not being rebranded or marketed as sustainable funds (at least not yet), the fact that they now consider ESG could be a way to sell them to consultants and advisers looking for ESG funds, allowing them to grab some of the growing ESG market share and stem the tide of outflows from these actively managed funds.
Indeed, there is a clear distinction to be made between these ESG consideration funds and those with a more fulsome commitment to sustainable investing. In a previous report, I identified 231 funds that fit into two other types of funds that more fully integrate ESG criteria throughout their investment processes. I called them ESG integration funds and impact funds.
The typical ESG integration fund's portfolio is tilted toward companies that its managers believe are addressing material sustainability challenges in ways that will make them better investments and away from companies that are not. ESG integration funds typically have better Morningstar Sustainability Ratings than ESG consideration funds.
Exclusionary Screens
It's not uncommon for ESG integration funds to use some exclusionary screens. Many also actively engage with the companies they own about ESG issues and are willing to sponsor or co-sponsor shareholder resolutions, to vote in favour of ESG-related resolutions, and to work together to promote sustainable finance more broadly. Most ESG integration funds are marketed as sustainable offerings and include key terms like "ESG" or "sustainable" in their names.
Impact funds take things a step further by attempting to generate measurable social and environmental impact alongside financial return. Impact funds are often focused on specific themes, such as low carbon, gender equity, or green bonds. Some use the UN Sustainable Development Goals as a framework for evaluating the overall impact of their portfolios. While some impact funds downplay ESG evaluation in security selection in favour of impact criteria, most employ ESG integration along with impact objectives. Increasingly, impact funds are measuring and reporting on their impact to investors. Not surprisingly, many are also using the term "impact" in their names. The impact group is also growing, and a number of ESG integration strategies have added impact criteria.
Those who want to orient their investments around sustainability and impact should focus on ESG integration and impact funds, and the ranks of these offerings are also growing rapidly. And while they should be aware of the differences between ESG integration and impact funds, on the one hand, and ESG consideration funds, on the other, the growing number of choices is good for investors.
On balance, sustainable investors have been arguing for years that ESG consideration should become a routine part of investing. The rapidly increasing number of ESG consideration funds demonstrates that this is happening.
