Choosing the Right Sustainable Fund (Part 2)

What to understand about a fund and the sustainable index it tracks.

Kenneth Lamont 22 October, 2020 | 12:33
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In part 1 of this article, we discussed some of the considerations on the index when choosing a passive sustainable fund. In this part, we will continue looking at the index level and also discuss the considerations on the fund level.

Even within approaches, strategies can differ dramatically. Some funds look a lot like their starting universes, while others venture further from their starting points to offer strong exposure to ESG leaders. For example, MSCI Universal and MSCI SRI index strategies both use the same MSCI ESG scoring system, but the former heavily reweights a lightly screened parent index, while the latter selects only the top quartile of ESG scorers using market weights.

  • Securities Selection and Weighting. It is important to understand the extent to which the fund is pursuing firms with strong ESG characteristics. A fund’s securities selection and weighting approach has a big impact on the type of ESG exposure it delivers.
  • Tracking Error. Tracking error and active share (a measure of the percentage of stock holdings in a fund's portfolio that differs from the benchmark index) both measure the level of active risk each fund takes versus its parent index. These are useful metrics for gauging how intensely a fund pursues ESG leaders and whether it might be appropriate as a core holding. There is trade-off between high ESG exposure on one hand, and broad diversification and low tracking error on the other. For example, those investors most committed to sustainability may favor the "purest" ESG exposure at the expense of a more-concentrated portfolio with higher tracking error. Investors seeking to replace a core portfolio allocation may be more willing to compromise on "purity" of ESG holdings (for example, accept less-compliant holdings) in exchange for retaining the benefits of diversification and lower tracking error.

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Kenneth Lamont  Kenneth Lamont is a Passive Funds Research Analyst for Morningstar Europe.

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