What Are Sustainable Funds and How Do They Work?

Sustainable funds are investment vehicles that incorporate environmental, social, and governance (ESG) factors into their investment selection. These funds aim to generate competitive financial performance while contributing to positive ESG outcomes. Fund managers consider how companies address issues such as climate change, human rights, labor practices, and corporate ethics when making investment decisions.

Defining Sustainable Funds

Sustainable funds integrate environmental, social, and governance (ESG) factors into their investment selection process. They pursue a dual objective: generating competitive financial performance while simultaneously contributing to positive ESG outcomes.

The “E” in ESG refers to environmental criteria, including a company’s carbon footprint, energy efficiency, waste management, water usage, and efforts to combat pollution and protect biodiversity. The “S” stands for social criteria, encompassing a company’s relationships with its employees, customers, suppliers, and the communities in which it operates. This includes factors like labor standards, diversity and inclusion, human rights, product safety, and community engagement. The “G” represents governance criteria, which relate to a company’s leadership, executive compensation, audits, internal controls, and shareholder rights. This pillar assesses the integrity and effectiveness of a company’s management and board.

Sustainable funds identify companies that exhibit responsible practices, aiming to minimize negative externalities and support businesses with strong ethical foundations. Companies with robust ESG practices are often better managed, more resilient, and better positioned for long-term success. The Securities and Exchange Commission (SEC) has proposed rules to enhance transparency around how funds incorporate ESG factors into their strategies.

Investment Strategies for Sustainable Funds

Sustainable funds employ various strategies to integrate ESG considerations into their portfolios. One prevalent approach is ESG integration, where fund managers systematically incorporate ESG factors into their financial analysis to identify risks and opportunities. This involves assessing how ESG issues could impact a company’s financial performance, leading to more informed investment decisions.

Another common strategy is negative screening, which involves excluding certain industries, companies, or practices from a fund’s investment universe based on specific ESG criteria. For instance, a fund might exclude companies involved in tobacco, controversial weapons, fossil fuels, or gambling. Conversely, positive screening focuses on selecting companies that demonstrate strong ESG performance or leadership within their sectors. This approach aims to invest in businesses with high sustainability ratings or innovative solutions.

Thematic investing concentrates investments in companies positioned to benefit from specific sustainability trends or themes. Examples include funds focused on renewable energy, clean water, or sustainable agriculture. These funds aim to capture growth opportunities associated with the transition to a more sustainable economy. Impact investing seeks to generate measurable social and environmental impact alongside financial returns. Impact funds often invest in private companies or projects designed to address specific issues, such as affordable housing or access to clean energy.

Fund prospectuses detail these strategies, explaining how the fund intends to achieve its investment objectives while adhering to its sustainability focus. The Department of Labor (DOL) has clarified that fiduciaries of retirement plans governed by ERISA may consider ESG factors when making investment decisions, provided these factors are relevant to a risk-return analysis.

Assessing Fund Sustainability

Evaluating the sustainability claims and performance of funds involves examining various metrics and third-party assessments. A primary tool for this is the use of ESG ratings provided by specialized agencies. These agencies collect extensive data on companies’ environmental, social, and governance practices, using hundreds of indicators to evaluate performance. Factors like greenhouse gas emissions, labor practices, board diversity, and ethical standards are analyzed to generate a comprehensive ESG score.

ESG rating methodologies are not always uniform across different agencies, meaning a company’s ESG score can vary depending on the provider. Agencies gather data from company sustainability reports, financial statements, and public records. The output typically includes a numerical score, alphabetical grade, or a relative grading system, which investors use to assess a company’s long-term sustainability and risk management.

Investors can assess fund sustainability by reviewing detailed fund reports and disclosures. Funds that consider environmental factors might disclose their portfolio’s carbon footprint. Fund prospectuses and annual reports provide insights into the fund’s specific methodologies for including or excluding assets, as well as information on how the fund has voted on ESG-related proxy proposals. The Securities and Exchange Commission (SEC) has proposed rules to enhance these disclosures, aiming for more consistent information across ESG funds to prevent “greenwashing.”

Various reporting frameworks guide companies and investment funds in disclosing ESG information, such as the Global Reporting Initiative (GRI), the Sustainability Accounting Standards Board (SASB), and the Task Force on Climate-related Financial Disclosures (TCFD). These frameworks provide standardized approaches for reporting on ESG matters. The process of assessing fund sustainability combines quantitative ratings with qualitative insights from official documents and adherence to recognized reporting standards.

Locating Sustainable Funds

Identifying and researching sustainable funds requires accessing various resources that provide detailed information on their investment objectives and ESG integration. A primary source of information is the fund prospectus, a legally required document outlining the fund’s investment goals, strategies, risks, and expenses. For sustainable funds, the prospectus details how ESG factors are incorporated into the investment process, including any specific exclusions or thematic focuses. Many fund providers also offer a summary prospectus and other information on their websites.

Fund provider websites often feature dedicated sections for their sustainable or ESG-focused offerings. These sites typically provide fact sheets and impact reports that elaborate on the fund’s approach to sustainability and its measurable outcomes. This direct access to information from the fund manager can help investors understand the nuances of a fund’s sustainable investment philosophy.

Independent research platforms and databases are also powerful tools for locating sustainable funds. Organizations like Morningstar, MSCI, and Sustainalytics offer ESG ratings and analysis for a wide range of funds and companies. These platforms allow investors to screen funds based on their ESG scores, specific sustainability themes, or exclusionary criteria. Some tools provide insights into a fund’s carbon footprint or alignment with global climate targets.

Engaging with financial advisors who specialize in sustainable investing can also be beneficial. These advisors possess expertise in navigating the complex landscape of ESG funds and can help investors identify options that align with both their financial objectives and sustainability preferences. Online brokerage platforms often include filters and search functions that allow users to identify sustainable funds within their investment offerings. While fees for sustainable funds were historically perceived as higher, recent studies indicate they are now comparable to or even lower than conventional funds.