So what’s in the portfolio of a fund manager that carries “Leader” status under Morningstar’s new ESG Commitment Level rating?

Morningstar analysts have been assessing 40 fund managers for their ESG credentials. As a report this week showed, six made the top category, or Leader board. For argument’s sake, let’s look at a Leader fund that wears its ESG colours on its sleeve, Australian Ethical’s Australian Shares fund.   

As of the end of September, the fund’s top ten portfolio holdings are: Macquarie Telecom Group; Healius; Bigtincan; Contact Energy; Westpac; Bank of Queensland; Nitro Software; NAB; Cochlear and Mirvac. And as per its ethical investing code, which was established in 1986 and contains 23 principles, the strategy has virtually no exposure to mining or energy, which is highly unusual, says Morningstar analyst Ross MacMillan.

“There are two ways to look at strategies that focus on the environmental, social and governance credentials of companies," says MacMillan.

“Are the managers of such funds good at assembling a portfolio of companies that will beat the index? And do they have good procedures for ESG?”

“Australian Ethical have built considerable knowledge and skill in this area, led by Dr Stuart Palmer."

Like most ESG-centric strategies, Australian Ethical excludes companies that fail to pass its ethical charter. But it also actively seeks companies that adhere to it, such as those in healthcare.

“The positive screens direct the portfolio manager toward companies that, in the firm’s assessment, constructively contribute to a better world, including by undertaking activities that add to human happiness, dignity, health, and education,” MacMillan says. “The negative screen results in the strategy avoiding certain stocks and sectors, particularly mining and energy.”

Australian Ethical Australian Shares (3921) – 10YR

a chart showing the 10yr performance of Australian Ethical Australian Shares

Source: Morningstar Premium

However, since mining companies comprise 30 per cent of the ASX 200, such exclusions arguably entail risks for investors. “If the oil price rises, for instance, and mining and energy sectors run really hard, a fund like Australian Ethical will get left behind,” MacMillan says.

Another point to note in the case of Australian Ethical is the inclusion of some smaller companies. Because it filters out much of the ASX 200, Australian Ethical ends up fishing among the small-cap stocks, hence the inclusion of Bigtincan and Nitro Software, both software providers, with market caps of between $460 million and $580 million. Both have done rather nicely, lately, too.

Nitro Software (NTO), Bigtincan (BTH) – 10YR

a chart showing the 10yr performance of Nitro Software and Bigtincan

Source: Morningstar Premium

As for performance, Australian Ethical Australian Shares has beaten both benchmarks. Its ten-year trailing return is 10.67 per cent versus 3.24 per cent for the index. It has also outpaced its peers (8.98 per cent).

But it’s important to remember that an ESG rating is to be considered separately from Morningstar’s other ratings. Australian Ethical Australian Shares is rated Neutral, for instance. And a key reason is price. Sorting the “good” companies from the “bad” costs money. And this is reflected in a management fee that is almost double the average.

Morningstar’s new ESG ratings are covered in-depth this week. A nice way to begin is by watching this short discussion between Morningstar’s director of investors education Karen Wallace and Alyssa Stankiewicz, an analyst on Morningstar's Manager Research team.

Once you’ve watched that, we have a couple of straightforward explainers, which will help you understand which strategies rise above the crowd in their commitment to ESG. And then have a look at Emma Rapaport’s survey of the top five sustainable funds.

Speaking of funds, in Firstlinks, Graham Hand stops to consider the term underperforming and shows its meaning fluctuates much like the market. Hand also has a fascinating interview with Graeme Shaw of Orbis, who explores the rise in the Nasdaq despite flat earnings and why he thinks we are at a critical moment in investing history.

Elsewhere, Morningstar’s Andrew Willis argues the US election has unlocked the massive marijuana market.

Amy Arnott forces you to check whether your portfolio is too heavy on tech stocks and how you might like to consider a counterweight.

The creator of the 4 per cent retirement rule, Bill Bengen, outlines the strategy, which purportedly ensures retirees they won’t run out of money.

Annalisa Esposito talks to fund managers to see which companies are benefiting from the shift to low carbon.

We look at the effect of China’s ban on some Australian commodities, particularly Treasury Wine Estates.

Morningstar senior equity analyst Dan Wasiolek weighs the listing of Airbnb and argues the online rental marketplace has a comfortable network advantage.

Dan Lefkovitz wonders whether the post-election small-value rally will last.

In Your Money Weekly, Peter Warnes ponders the merits of thoughtful disagreement in weighing the opposing views of what lies ahead next year.

And finally, Brian Han devotes his Brianstorm column to the IPO scene and urges buyer beware as a surging market and insatiable demand for technology and “In-Home” shares jam the float pipeline.

Morningstar's Global Best Ideas list is out now. Morningstar Premium subscribers can view the list here.

See also Morningstar Guide to International Investing.