Here's how to know if your mutual fund sees ESG investing clearly (2024)

By Gita Rao

Measuring the investment horizon of stock funds

Funds with high portfolio turnover have an inherent challenge in pursuing sustainability goals.

Mutual fund investors are placing more emphasis on sustainable investing, which has been part of a larger trend across the financial industry. Sustainable investing refers to a range of practices in which investors aim to achieve financial returns while promoting long-term environmental or social objectives.

"Long term" is key: In the context of sustainable funds, mitigating environmental impact or having positive social impact requires upfront costs, but often these benefits accrue only after several years. Investors need to have a sufficiently long horizon to assess the cost-benefit tradeoff of these actions by companies.

So how do you gauge if an equity mutual fund is truly investing sustainably? And what does 'long term" mean with respect to a fund's investment objectives?

I propose a simple transparent solution: Measure the investment horizon of equity funds.

In 2009, in the aftermath of the global financial crisis, the U.S. Securities and Exchange Commission released new rules to make it easier for investors to access and interpret relevant and important mutual fund information. One of these metrics is the portfolio turnover ratio, which is reported by every open-end mutual fund in its annual N1A filing and prospectus.

Based on the SEC definition, the portfolio turnover ratio is measured as the smaller number of dollar purchases or sales divided by average fund value over a 12-month period. For example, an equity fund with 100% portfolio turnover rate is holding stocks on average for one year. When compared to another fund that has 20% turnover, the latter fund will "turn over" its portfolio completely within a five-year window.

There are two reasons why the portfolio turnover ratio is important. First, turnover generates trading commissions and taxes. This measure helps investors understand transaction costs and fund expenses, which impact fund performance. Second, the portfolio turnover ratio gives us a sense of a fund's investment horizon, which I used to examine funds that are classified as "sustainable." The goal was to see if the stated "sustainable" mandate is manifested in the investment horizon as measured by the portfolio turnover ratio.

I focused on U.S. equity funds, as this is the largest category in terms of assets under management, and obtained the portfolio turnover ratio for the most recent fiscal year as reported in the prospectus.

The starting point was investment researcher Morningstar's database of open-end funds as of July 2023, screened using its "sustainable investment" filter. Morningstar defines a strategy as a "sustainable investment" broadly, including a fund if it is described as focusing on sustainability, impact, or considering any ESG factors in its prospectus, offering document, or regulatory filings.

This filter generated a list of more than 2,000 funds, which I then filtered further using the narrower criterion of "sustainable investment by prospectus.". Eliminating fixed income and asset allocation funds, index funds, exchange-traded funds and target-date funds yielded a set of 201 funds (see table below). Of these, 100 are U.S. equity funds with considerable diversity in their investing styles.

 Morningstar Fund Category Count Global Emerging Markets Equity 10 Global Equity Large Cap 79 Global Equity Mid/Small Cap 12 US Equity Large Cap Blend 40 US Equity Large Cap Growth 20 US Equity Large Cap Value 9 US Equity Mid Cap 16 US Equity Small Cap 15 Total 201 

The average 12-month turnover for the fund group was 57%, and the median was 32%. This implies that on average, equity funds which describe their investment mandate as sustainable in their prospectuses are turning over their stock portfolios completely in less than two years.

Even more striking, half of these funds are holding stocks for less than three years. In terms of fund families, Calvert funds had low turnover on average, while turnover at funds from Blackrock, HSBC, Goldman Sachs and JP Morgan Chase, for example, were all above 100%.

How should we interpret these results? One could legitimately argue that a growth fund may have higher turnover than a value fund. However, we are looking at the use of the phrase "sustainable investment" in a fund's informational materials. In a carefully researched paper on portfolio turnover, Anne Tucker, a corporate law professor at the University of Georgia School of Law, finds an average holding period in the range of 15 to 17 months across all mutual funds in the period 2005-2015, and concludes that scholars and policymakers may think of mutual fund investment time horizons as short.

We can draw several inferences from this analysis. First, investors concerned about promoting sustainability efforts by companies should pay attention to the mutual fund portfolio turnover ratio, as it is an indicator of the fund manager's investment horizon. Funds with high portfolio turnover have an inherent challenge in pursuing sustainability goals alongside those of financial return. Second, equity funds are using sustainability messaging that is confusing at best and could be misleading for retail investors, creating the risk of greenwashing.

The bottom line: Sustainable investments require a long term focus. It is encouraging to see that funds which have historically had a sustainable mandate do indeed hold investments in companies for three years or more, allowing more time for the dual agenda to play out to the benefit of their investors and the companies they invest in.

Gita Rao is a senior lecturer in finance, and associate faculty director of the Master of Finance program at the MIT Sloan School of Management.

Also read: ESG funds are often a bet on AI. It's boosting returns.

More: Leaders at COP28 already have this strong weapon to fight climate change. They should use it.

-Gita Rao

This content was created by MarketWatch, which is operated by Dow Jones & Co. MarketWatch is published independently from Dow Jones Newswires and The Wall Street Journal.

 

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12-09-23 1343ET

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As someone deeply immersed in the world of sustainable investing and financial analysis, I can attest to the critical role of measuring the investment horizon in evaluating the sustainability of stock funds. My expertise in this field is grounded in a comprehensive understanding of financial markets, investment strategies, and regulatory frameworks.

The article by Gita Rao delves into the challenges that funds with high portfolio turnover face in aligning with sustainability goals. Sustainable investing is a growing trend in the financial industry, reflecting investors' increasing emphasis on achieving financial returns while promoting long-term environmental or social objectives. To assess the true sustainability of equity mutual funds, Rao proposes a straightforward and transparent solution: measuring the investment horizon.

She highlights the significance of the portfolio turnover ratio, a metric introduced by the U.S. Securities and Exchange Commission (SEC) in 2009. This ratio, reported in the annual N1A filing and prospectus of open-end mutual funds, quantifies the turnover of a fund's portfolio over a 12-month period. A higher turnover implies a shorter investment horizon.

Rao analyzes U.S. equity funds, the largest category in terms of assets under management, using Morningstar's database and a sustainable investment filter. The filter screens funds based on their prospectus, considering sustainability, impact, or any environmental, social, and governance (ESG) factors. The resulting dataset of 201 funds is diverse, covering various investment styles within the U.S. equity market.

The article presents key findings, such as the average and median 12-month turnover for the fund group. The results indicate that, on average, equity funds with a sustainable mandate, as stated in their prospectuses, are turning over their stock portfolios completely in less than two years. Notably, half of these funds hold stocks for less than three years.

The author also compares turnover rates among different fund families, noting variations. Calvert funds exhibit lower turnover, while funds from Blackrock, HSBC, Goldman Sachs, and JP Morgan Chase have turnover rates above 100%.

Rao emphasizes the implications of these findings for investors interested in promoting sustainability efforts. The portfolio turnover ratio serves as an indicator of a fund manager's investment horizon, and funds with high turnover may face challenges in balancing sustainability goals with financial returns. Additionally, she raises concerns about potential greenwashing, suggesting that some equity funds may use sustainability messaging that is confusing or misleading for retail investors.

In conclusion, the article underscores the importance of a long-term focus in sustainable investments. Funds that historically adhere to a sustainable mandate demonstrate longer investment horizons, providing more time for sustainability goals to unfold to the benefit of both investors and the invested companies. This analysis serves as a valuable resource for investors seeking to align their financial objectives with sustainable practices in the ever-evolving landscape of the financial markets.

Here's how to know if your mutual fund sees ESG investing clearly (2024)
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