The ordinary investor is more likely to have most of his money in mutual funds than individual stocks or bonds, but until recently there have been few options to determine how sustainable these funds may be.  

In March, investment research company Morningstar rolled out the first sustainability ranking for mutual funds, where companies are ranked on their environmental, social and governance (ESG) performance and compared to their industry peers.

Morningstar’s ranking has been applied to over 21,000 mutual funds and exchange-traded funds globally that total $13 trillion in assets under management. The ranking is available on Morningstar’s website.

"This is a bigger deal than one would think at first blush," said Natasha Lamb, director of equity research and shareholder engagement at Arjuna Capital. "It really does democratize access to more sustainable investments."

Lamb mentions that prior to the ranking, employees had few options if they wanted to figure out whether their retirement funds held sustainable companies.

"The vast majority of people don’t have the luxury of understanding the ESG profile of their investment because there are so few publicly traded mutual funds and ETFs focused on sustainability," said Lamb.

Ranking sustainability

Morningstar’s sustainability rankings are calculated using a two-step process: determining a fund’s portfolio sustainability score; then determining its sustainability score relative to its peers.

In order to calculate a fund’s portfolio sustainability score, Morningstar first gathers individual company ESG scores in the funds, which are calculated by the analytics firm Sustainalytics.

Sustainability is starting to become more integrated, especially in large multi-national companies.

Morningstar then compiles an asset-weighted average of the funds’ portfolio using the ESG scores, where a fund’s score is deducted for controversies including fraud, discriminatory behavior or environmental grievances.

After calculating the portfolio score, Morningstar compiles its sustainability ranking by comparing a fund’s portfolio score to 10 other companies in its industry. Ratings range from one to five, from lowest to highest.

In its initial findings, Morningstar found that out of 20,000 funds 10 percent received a ranking of five, 35 percent received a ranking of three and 10 percent received a ranking of one.

"It does suggest that they are doing what they (mutual funds) say they are doing," said Jon Hale, Morningstar’s head of sustainability research. "Before this rating, there was really no way of determining how to do that."

Within individual companies, Hale said sustainability is starting to become more integrated, especially in large multi-national companies.

"They’ve really started to evolve where they are taking corporate sustainability issues more seriously," said Hale.

From impact investing to just investing

Historically, investing in sustainable companies has been associated with "do-good" or impact investors, but now it is becoming a bigger trend throughout the investment community.

A survey conducted by Morgan Stanley showed that more than 70 percent of active individual investors say they are interested in sustainable investing, specifically among millennials and women, according to the Wall Street Journal.

It’s no longer investing plus sustainability. ... It’s just investing.

Hale said investors are, for the most part, no longer just concerned about one sustainability or environmental issue such as climate risk or sustainable supply chains, but rather a broad array of issues.

"The general interest in sustainability issues is not as clearly specific to a particular issue or set of issues as it is this general concept," said Hale. 

Financial institutions such as BlackRock and Goldman Sachs recently have made a push toward introducing funds that target sustainable companies. 

BlackRock, the world’s largest asset manager with $4.5 trillion under management, launched an impact investing mutual fund last year, and has over $200 billion of assets in ESG and impact funds overall.

In a report by the Forum for Sustainable and Responsible Investing (U.S. SIF), assets "engaged in sustainable, responsible and impact investing practices" accounted for close to 18 percent of $36.8 trillion in total assets under management at the beginning of 2014.

This is also a 929 percent increase from 1995 when U.S. SIF started tracking social and responsible investing.

"It’s no longer investing plus sustainability," said Lamb. "It’s just investing, and with these funds we are finally starting to see that."

Defining sustainability

However, only a few funds specifically target environmental or sustainable companies, and evaluating whether companies are actually sustainable can be difficult.

Funds with explicit sustainable or responsible investment mandates comprise only about 2 percent of the fund universe.

According to Morningstar, "funds with explicit sustainable or responsible investment mandates comprise only about 2 percent of the fund universe."

In an article in the Wall Street Journal, David Vogel, a professor of business ethics at University of California at Berkeley, discussed the difficulty of determining whether a company is truly socially responsible because its actions can offer a mixed interpretation.

"Should Dow Chemical be excluded from a sustainability-screened portfolio because of past pollution or included because of its recent leadership in tracking and reducing its environmental impact and that of its products?" said Vogel.

But regardless of the difficulties of evaluating sustainable investments, Lamb said that these ratings will bring increasing attention toward sustainability.

"This is a whole different game than the past because the public’s eye is on these companies and their behavior," said Lamb.