Sustainable investors have a range of international-stock fund choices

For those interested in building a portfolio around sustainable investing, this may be a good time to select a core international-stock fund. International stocks have outperformed U.S. stocks so far this year, prompting investors to pump money into international-stock funds. That’s not a bad idea for those who may have let their non-U.S. equity allocation dwindle since the market bottomed in early 2009 as international stocks lagged well behind their U.S. counterparts over that period. Many investors probably remain underexposed to international stocks even after this year’s first-half performance.

With 14 open-end funds and three ETFs that focus on non-U.S. equities in developed markets, sustainable investors have an array of choices to choose from for their core international exposure. These are funds that clearly state, by prospectus, that sustainable investing is an integral part of their investment process. Seven are active funds, seven are index funds, and three others are passive or quasi-passive portfolios based on indexes.

Performance has been good so far this year, with 11 of 16 beating the MSCI EAFE index through June. (The Fidelity fund launched this year, so it doesn’t have a year-to-date return.) That’s about typical for all foreign large-cap funds, with about 70% beating the index in the first half. The two top performers, JHancock ESG International Equity and Boston Common International, are both run by Boston Common Asset Management. The first- half returns of those two funds, along with those of Domini Impact International Equity, placed in the top decile of their Morningstar categories.

Only seven of the sustainable international developed-markets funds have longer-term records, though, complicating the selection process considerably. The good news is that five of the seven have beaten the MSCI EAFE Index for the trailing three years, and three have won out over the index for the trailing five years. The five-year returns of the Domini fund, subadvised by Wellington Management, outpaced all others by a healthy margin and ranks near the top of the Morningstar Foreign Large Value category.

Twelve of the funds have Morningstar Sustainability Ratings of 4 or 5 globes, and only one has a Sustainability Score ranking in the bottom half of its category. That means, on average, the companies of stocks held in these funds tend to score better on a range of environmental, social and corporate governance, or ESG, criteria than do those in most conventional foreign-stock funds. That’s not surprising because all but one of the 17 funds employ a range of ESG criteria in their stock-selection process. (The SPDR MSCI EAFE Fossil Fuel Free ETF employs a simple exclusion for companies that own fossil fuel reserves.)

As a result, the typical sustainable international-stock fund has a somewhat different risk profile than the MSCI EAFE Index. Running the funds through the Morningstar Risk Model revealed differences on six risk factors. Compared with the index, the sustainable funds have slightly higher valuations, stronger economic moats, and exhibit less returns volatility and momentum. Sustainable funds hold somewhat smaller stocks than those of the index and the active sustainable funds are more growth-oriented. This is generally consistent with what we know about companies that do well on sustainability criteria. They tend to be quality growth companies with lower risk.

The sustainable portfolios differ hardly at all from the index in terms of their sector exposures. Active sustainable managers had slightly more exposure to technology and less exposure to financials, and passive sustainable managers had slightly less exposure to energy. Because several funds have broader mandates that allow them to invest in emerging markets and/or Canada, the sustainable group has somewhat less exposure to Europe. Overall, a sustainable investor need not be too concerned about getting skewed sector or regional exposures. If emerging markets exposure is desired, several funds have significant stakes, including the new Fidelity International Sustainability Index Fund, which tracks the MSCI All Country World ex U.S. ESG Index. Sustainable funds otherwise look a lot like conventional funds, except they tilt towards companies that do better on ESG criteria.

Most of the sustainable funds also employ some product or activity exclusions. Some of the more frequently used exclusions have to do with guns and controversial weapons, gambling, tobacco, and alcohol, military contracting, coal and nuclear power. The sustainable funds have an average exposure of 5.6% to these areas, which is much lower than the index’s 15.5% exposure. Finally, some sustainable funds practice what I call “active ownership”, which means they engage with company management on material ESG issues and typically support ESG-related shareholder resolutions.

Investors can widen their scope by incorporating the Morningstar Sustainability Rating into their conventional selection process. A quick search of large-cap foreign stock funds with five globe ratings, for example, yielded Gold-rated Harbor International Inv and Bronze-rated T. Rowe Price Overseas Stock. These funds don’t explicitly integrate ESG into their selection process, use exclusions, or practice active ownership on ESG issues, but they are established, successful funds that hold stocks of companies that do well on ESG analysis.

Investors wanting a core international equity fund that’s more committed to sustainability issues can choose among funds that have strong ESG profiles, minimal exposure to various exclusions, and are active owners. They’ll generally find themselves invested in lower volatility stocks of quality growth companies, which is generally a good recipe for a successful long-term investment.

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