What are we looking for?
Mutual funds that have outperformed peers and have taken on less ESG risk.
The screen
All investors must contemplate a tradeoff between risk and return. The more risk an investor agrees to take on, the greater the expected return of the investment should be. In the realm of risk, a read over any investment fund’s prospectus will reveal an eye-watering number of them (credit risk, market risk, liquidity risk, to name a few). All risks have a couple of things in common: They are financially material to an investment’s long-term outcome, but they may or may not materialize over short periods.
One type of risk that is often misunderstood but talked about constantly is ESG risk. Putting aside political views for a moment, it is important to reiterate that ESG risks (or risks stemming from environmental, social or governance factors), like all other types of risk, may or may not materialize in the short term. However, they are validly linked to real-world risks that don’t necessarily appear on a company’s financial statements.
One tangible example that applies to many companies is around labour laws and general employment practices. A company that has weak or poor policies in this area may be more susceptible to protests or strikes (Amazon.com Inc. comes to mind), which directly affects investors’ bottom line. Though this type of risk may not materialize in every case, as an investor it is a worthwhile consideration regardless of where your political views lie.
Along this vein, today I use Morningstar Direct to screen for Canadian-domiciled mutual funds that have not only outperformed their peers over long stretches of time but also exhibit low degrees of ESG risk within their portfolio. To do so, I screened for funds that:
- have received a Morningstar Rating for Funds (informally known as the “star” rating) of four or five stars. This rating is an objective look back at the risk-adjusted after-fee performance of the fund, relative to its category peers. The rating considers the past 10 years of performance history, if available, and puts greater emphasis on recent performance history. Our data show that although the star ratings are backward-looking, funds that have received five stars as a group outperform those that have received four stars, three stars etc. in periods after receiving the rating. In other words, it’s more likely that a fund manager with a track record of outperforming peers will continue to outperform in the future, while those that have historically underperformed peers will continue to do so;
- have received a Morningstar Sustainability Rating of five globes. Not to be mistaken as a measure of “greenness” or “goodness,” the rating is a measure of how well the companies held by a fund are managing their ESG risks and opportunities when compared with similar funds. We use company-level ESG data from Sustainalytics, a leading provider of ESG ratings and research, to calculate the rating.
For consistency, only fee-based share classes of mutual funds were considered in the search, noting that the MERs displayed do not include the fee that is charged by an adviser, separately, for advice and for managing your investments.
What we found
The funds that qualified in the screen are listed in the table accompanying this article, alongside categories, MERs, trailing performance, inception dates and ratings. Investors are urged to first look at the category to which each fund belongs, given that the rating is meant to measure performance against category peers. I also note importantly that none of these funds advertise themselves as “ESG” or “sustainable” funds. This is an important point in line with the theme of today’s article – investors (and fund managers) might consider ESG risk in the investment process purely to pursue better risk-adjusted returns. The performance of these funds is a testament to this.
This article does not constitute financial advice. It is always recommended to conduct one’s own independent research before buying or selling any of the funds or ETFs mentioned in this article.
Ian Tam, CFA, is director of investment research for Morningstar Canada.
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Ian Tam, CFA