How to Take a Passive Approach to Sustainable Investing

Investment choices also have increased, with Morningstar stating it has tagged 2,800 funds, which collectively have nearly $970 billion in assets, in its database as "socially conscious." Most of these funds are actively managed, however. As of Dec. 31, 2017, Morningstar, in its study Passive Sustainable Funds: The Global Landscape, found there were nearly 270 sustainable index mutual funds and ETFs globally that had $102 billion in AUM, a threefold increase over five years.

The paper, which studied the trends in asset growth, asset flows and product development, mainly in the United States and Europe, found:

• Europe still is the largest region for index-tracking sustainable funds with 85% of global assets, although U.S. assets have quadrupled over the last five years.
• Sustainable passive fund market share has increased to 12% of assets globally, doubling in five years.
• Broad-based ESG funds dominate the passive fund landscape, the study said, although thematic funds that focus on climate change and gender diversity are gaining interest with investors.
• Index methodology has grown more complex, especially in regard to security selection and weighting approaches.
• Most sustainable investing growth has come from institutional investors, but individual interest in growing rapidly.
• Fee-wise, passive sustainable funds across regions tend to have higher expense ratios than plain vanilla passive funds, although are less expensive than actively managed funds.
• MSCI is the leader in the sustainable indexing space, with FTSE Russell as next largest.
• Sustainable passive ETFs are more prevalent in the U.S. than Europe, where open-ended funds are larger both in numbers and assets.

In determining whether to utilize sustainable passive funds or indexes, Morningstar included a list of considerations that managers should use. When reviewing an index or ETF, the report states, "not all sustainable indexes are created equal," therefore an advisor needs to understand the rules that govern them:

1. ESG focus and metric: Does the focus of the index match the ESG components the manager wants to emphasize?
2. Exclusions: Beware of what is excluded in the makeup of the index, as it could have a financial impact that doesn't align with overall investment objectives.
3. Sector and geographic bias: Understand what global regions or sectors make up the index. Europe is a leading region for sustainability, while emerging markets typically are not strong. Sectors such as oil & gas have low ESG ratings.
4. Tracking error relative to a broad market: Watch out for factors that include security-selection methodology, exclusions and weighting schemes. Optimization can be used to minimize tracking errors.

For sustainable index mutual fund investments, advisors need to keep an eye on:

1. Fees that are higher than ordinary passive peers'.
2. Performance that may be hard to garner because of short track records. In this regard, closely review back tests, which can be manipulated.
3. It's better to have asset managers who are engaged with companies on several ESG issues and are advocates to effect change.

— Check out Socially Responsible Investing Designation for Advisors to Debut This Fall on ThinkAdvisor.