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Screening investments for sustainability

A surge in socially conscious investing is inspiring the development of analytical tools for evaluating the sustainability of portfolios. Kyle Tetting explains in a Money Talk Video interview with Joel Dresang.

Joel Dresang: Kyle, the independent investment research firm Morningstar recently started rating mutual funds based on the social responsibility of their investments. Why?

Kyle Tetting: Joel, we’ve seen over $7 trillion go into sustainable and responsible investing. It represents roughly one in six U.S. professionally managed dollars. So we’ve seen some pretty substantial in-flows.

As a result, you have independent firms, like Morningstar, trying to put a better understanding under what those terms actually mean for individual investors and to try and quantify not just whether a fund is or isn’t responsible, but how responsible it is.

Joel: So how does this Morningstar Sustainability Rating work?

Kyle: You know, ultimately, what Morningstar is doing is taking data from another firm, Sustainalytics. They’re aggregating that data on individual companies to come up with a rating for their funds.

Now, what they’re looking at is environmental scores, societal scores and governance scores to get an idea of how each company rates in terms of those three factors, kind of the three pillars of responsible investing.

For the environmental piece, what we’re really talking about is how a company interacts with the world around them, specifically with respect to the way that they’re using their natural resources and their relationship with just the environment generally.

For the societal or the social piece, what we’re really talking about is how a company interacts with their employees, with their customers, with their supply chain.

And then for that governance piece, what we’re really looking at is how honest is a company about the way that they put together their financials. How honest are they about where their political contributions are going and what kind of impact they’re  trying to have on the world through those contributions.

The other piece that they do is they look at how involved in controversy a company is. So, have we had an oil spill with this company? Have we had governance issues? Are they being sued for something?

Joel: And the thought is that all of that reflects on how the company performs in the long-term?

Kyle: That’s correct. Ultimately, they build in those two things, the environmental, societal, and governance scores and the controversy score, into some kind of sustainability rating.

So how viable is this company long-term? Where are they going to need to make changes in order to remain in business in order to remain profitable?

And then what Morningstar does is they take all that company-level data and they build it up to a top-level view for each individual fund that you might invest in.

Joel: So how do they compare one company with another if they’re in different business – say a bank and an oil company?

Kyle: There are very different risks for oil companies than there are for banks. So what they do in order to kind of normalize for that is they look at oil companies versus other oil companies … they look at banks versus other banks to say not just “Okay, what kind of impact do you have on the environment, but relative to your peers, what kind of impact are you having?”

Joel: So how do I use these sustainability ratings in making a balanced, diversified portfolio?

Kyle: What we have found, and one of the reasons why we use the term sustainability, is that companies who tend to score highly tend to be businesses that are around for a long time. They tend to be business that are making good investment decisions for their investors.

What you get is an investment that tends to outperform over time or, at the very least, perform like its peers with a lot less risk because you’re not concerned about the environmental impact, you’re not concerned about a potential lawsuit down the road.

So, again, what you’re really getting is this investment that should be a little bit more sustainable over the long run. Who doesn’t want that in a balanced and diversified portfolio?

Joel: Kyle, where do you see this whole trend for socially conscious investing going?

Kyle: You know, Joel, we’re seeing more and more investors jump on board of the socially responsible investing – everything from young investors to sovereign wealth funds to private pensions and endowments that are recognizing that no longer does doing good have to be a perceived as a drag on performance. That you can do well by doing good.

Kyle Tetting is director of research and an investment advisor at Landaas & Company.

Joel Dresang is vice president-communications at Landaas & Company.

Money Talk Video by Jason Scuglik and Peter May

(initially posted June 29, 2016)

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