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Excluding Controversial Products from Moat Investing

15 March 2023

 

Morningstar® US Sustainability Moat Focus IndexSM combines Morningstar’s recognized equity research process of identifying companies with long-lasting competitive advantages and attractive valuations with Sustainalytics’ industry-leading ESG research. The Index focuses on three proprietary ESG criteria when selecting companies for inclusion: ESG risk, controversy, and carbon risk. As an additional layer, Systainalytics screens for product involvement, which we explore here.

Morningstar US Sustainability Moat Focus Index Methodology

Morningstar US Sustainability Moat Focus Index Methodology

  • ESG RISK: Companies must have an ESG Risk Rating categorized as medium, low or negligible.
  • Controversy: A company´s controversy score must be 4 (out of 5) or lower throughout the previous three years.
  • Carbon Risk: A company´s carbon risk score cannot be high or severe.
  • Product Involvement: A company must not be involved in tobacco, controversial weapons, civilian firearms or thermal coal.
  • Wide Moats: Only those companies with Morningstar’s wide economic moat ratings are eligible for inclusion.
  • Attractive Valuations: Only the most attractively priced wide moat companies are selected, based on a company’s current price relative to its Morningstar analyst-assigned fair value estimate.

Source: Morningstar and VanEck. As of 31/12/2022.

Considering Sustainability Risk

Sustainability risk refers to potential negative impacts on environmental, social, and governance (ESG) factors that can affect a company's financial performance, reputation, and long-term viability. It is important to consider sustainability risk as it can have significant financial, environmental, and social impacts, and regulatory requirements around those issues are increasing.

While the first three levels of Sustainalytics ESG screening provide comprehensive protection against ESG risks, Morningstar exclude companies in controversial industries and making unethical products. Four main industries are excluded: tobacco products, production of controversial weapons, involvement in the manufacturing of firearms sold to civilian customers, and extraction of thermal coal along with burning it for power generation.

Diving Into Direct and Indirect Involvement

Sustainalytics conducts product and revenue analysis for the companies considered to have wide moats, checking the percentage of revenues derived from controversial output, production capacity ranges and ownership structures. The latter plays a crucial role, as its involvement is additionally classified as:

  • Direct involvement: a company is directly involved in a product or service in one or more ways such as production, distribution, or related services; or
  • Indirect involvement: a company is indirectly involved in a product or service through ownership of an involved company (“significant ownership”).

Tobacco Production

Companies are assessed to see if they derive revenue from tobacco products including cigarettes, cigars, tobacco, electronic cigarettes, paper used by end consumers for rolling cigarettes, filters, snuff tobacco, etc. This includes tobacco products manufacturers, retailers and distributors, as well as companies providing tobacco-related products or services.

Tobacco is considered controversial because of the negative health consequences (cancer) of long-term use, also leading to substantial medical costs for society. Tobacco companies are exposed to significant financial and reputational risks as a result of legal cases and class actions brought against them.

Despite possible wide moat benefits and attractive valuations, we exclude companies deriving more than 50% of their revenue from tobacco products. One company excluded during the portfolio selection under this rule is Altria Group Inc. This US company makes cigarettes under the Marlboro brand and is one of the world’s largest producers of tobacco and cigarettes. The company also maintains stakes in cannabis and electronic cigarette producers.

Source: Morningstar, VanEck, Altria Group Inc, as of 31/12/2022.

Controversial Weapons

Companies are assessed to determine whether they manufacture controversial weapons or components, or provide services related to them.

Controversial weapons, in contrast to conventional weapons, have a disproportionate and indiscriminate impact on civilian populations, sometimes even years after a conflict has ended. Certain controversial weapons are illegal, as their production and use are prohibited by international treaties and bans. In various countries there is legislation in place regarding investments in controversial weapons. The key focus areas here are antipersonnel mines, biological and chemical weapons, cluster weapons, depleted uranium, nuclear weapons, and white phosphorus weapons.

Northrop Grumman is an example of a company involved in controversial weapons1. The company has a pool of nuclear weapons contracts that are illegal under international law, as well as a weapon equipment package that led to mass human causalities in the war in Yemen as a result of airstrikes. Besides, the company was invested in lethal autonomous weapons, which can be a significant threat to international security and peace.

Source: Morningstar, VanEck, United States Securities and Exchange Commission, as of 31/12/2022.

Manufacturing of Firearms Sold to Civilian Customers

Companies are assessed to see if firearms generate revenue for them. Gun makers, rifle makers, pistol makers, and component makers, as well as retailers, are included in this group.

Firearms can be considered controversial as they are reported to be a major factor in the increase of armed conflict worldwide. They are the weapon of choice for many terrorist groups around the world, and often hinder smoother rebuilding and development after a conflict has ended. Besides the loss of human life and physical harm, armed violence also has significant (direct and indirect) economic costs.

Thermal Coal Extraction and Power Generation

The purpose of this involvement area is to assess whether companies derive revenue from mining thermal coal, generating electricity from thermal coal or providing support products or services for mining thermal coal.

On a lifecycle basis, thermal coal is more carbon intensive than other fossil fuel sources, while from an energy generation perspective it can easily be substituted. Thermal coal – also known as energy coal, or steam coal – is mainly used in power generation.

Dominion Energy Inc, a US power and energy company, was excluded by Sustainalytics due to its coal usage. Despite plans to phase it out in the near future, coal still plays an important part in the firm’s processes.

Source: Morningstar, VanEck, Dominion Energy Inc, as of 31/12/2022.

The Morningstar’s Sustainable Approach to Moat Investing

Many of the most popular sustainable investment strategies offer broad exposure to market indexes while applying some level of exclusionary or inclusionary ESG screens. This may reduce ESG risk in a portfolio, but does not address other performance drivers. The Morningstar US Sustainability Moat Focus Index’s unique combination of forward-looking equity research and ESG screening offers investors a U.S. equity strategy that seeks to provide investors with attractive risk-adjusted returns while mitigating ESG risks.

VanEck Morningstar US Sustainable Wide Moat UCITS ETF aims to replicate as closely as possible, before fees and expenses, the price and yield performance of the Morningstar US Sustainability Moat Focus Index. The ETF is categorized Art. 8 as per Regulation on sustainability‐related disclosures in the financial services sector (“SFDR”) and promotes, among other characteristics, ESG characteristics.

1 https://www.sec.gov/Archives/edgar/data/1636143/000121465921004401/p22213px14a6g.htm

Important Disclosures

For informational and advertising purposes only.

This website originates from VanEck Asset Management B.V., a UCITS Management Company incorporated under Dutch law and registered with the Dutch Authority for the Financial Markets (AFM). The information is intended only to provide general and preliminary information to investors and shall not be construed as investment, legal or tax advice. VanEck Asset Management B.V. and its associated and affiliated companies (together “VanEck”) assume no liability with regards to any investment, divestment or retention decision taken by the investor on the basis of this information. The views and opinions expressed are those of the author(s) but not necessarily those of VanEck. Opinions are current as of the publication date and are subject to change with market conditions. Certain statements contained herein may constitute projections, forecasts and other forward looking statements, which do not reflect actual results. Information provided by third party sources are believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. All indices mentioned are measures of common market sectors and performance. It is not possible to invest directly in an index.

VanEck Asset Management B.V., the management company of VanEck Morningstar US Sustainable Wide Moat UCITS ETF (the "ETF"), a sub-fund of VanEck UCITS ETFs plc, a UCITS management company under Dutch law registered with the Dutch Authority for the Financial Markets (AFM). The ETF is registered with the Central Bank of Ireland and tracks an equity index. The value of the ETF’s assets may fluctuate heavily as a result of the investment strategy. If the underlying index falls in value, the ETF will also lose value.

Investors must read the sales prospectus and key investor information before investing in a fund. These are available in English and the KIIDs/KIDs in certain other languages as applicable and can be obtained free of charge at www.vaneck.com, from the Management Company or from the following local information agents:

UK: Facilities Agent -- Computershare Investor Services PLC

Morningstar® US Sustainability Moat Focus Index is a trade mark of Morningstar Inc. and has been licensed for use for certain purposes by VanEck. VanEck Morningstar US Sustainable Wide Moat UCITS ETF is not sponsored, endorsed, sold or promoted by Morningstar and Morningstar makes no representation regarding the advisability in VanEck Morningstar US Sustainable Wide Moat UCITS ETF.

All performance information is historical and is no guarantee of future results. Investing is subject to risk, including the possible loss of principal. You must read the Prospectus and KIID/KID before investing.

No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of VanEck.

© VanEck Asset Management B.V.

Important Disclosure

This is a marketing communication for professional investors only. Please refer to the UCITS prospectus and to the Key Investor Information Document (KIID) before making any final investment decisions.

This is a marketing communication for professional investors only. Please refer to the UCITS prospectus and to the Key Investor Information Document (KIID) before making any final investment decisions. This information originates from VanEck Securities UK Limited (FRN: 1002854), an Appointed Representative of Sturgeon Ventures LLP (FRN: 452811), who is authorised and regulated by the Financial Conduct Authority in the UK. The information is intended only to provide general and preliminary information to FCA regulated firms such as Independent Financial Advisors (IFAs) and Wealth Managers. Retail clients should not rely on any of the information provided and should seek assistance from an IFA for all investment guidance and advice. VanEck Securities UK Limited and its associated and affiliated companies (together “VanEck”) assume no liability with regards to any investment, divestment or retention decision taken by the investor on the basis of this information. The views and opinions expressed are those of the author(s) but not necessarily those of VanEck. Opinions are current as of the publication date and are subject to change with market conditions. Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results. Information provided by third party sources is believed to be reliable and have not been independently verified for accuracy or completeness and cannot be guaranteed. Brokerage or transaction fees may apply.

VanEck Asset Management B.V., the management company of VanEck Morningstar US Sustainable Wide Moat UCITS ETF (the "ETF"), a sub-fund of VanEck UCITS ETFs plc, is a UCITS management company under Dutch law registered with the Dutch Authority for the Financial Markets (AFM). The ETF is registered with the Central Bank of Ireland, passively managed and tracks an equity index. Investing in the ETF should be interpreted as acquiring shares of the ETF and not the underlying assets. Investors must read the sales prospectus and key investor information before investing in a fund. These can be obtained free of charge at www.vaneck.com, from the local information agent Computershare Investor Services PLC or from the Management Company.

Morningstar® US Sustainability Moat Focus Index is a trade mark of Morningstar Inc. and has been licensed for use for certain purposes by VanEck. VanEck Morningstar US Sustainable Wide Moat UCITS ETF is not sponsored, endorsed, sold or promoted by Morningstar and Morningstar makes no representation regarding the advisability in VanEck Morningstar US Sustainable Wide Moat UCITS ETF.
Effective December 17, 2021 the Morningstar® Wide Moat Focus IndexTM has been replaced with the Morningstar® US Sustainability Moat Focus Index.
Effective June 20, 2016, Morningstar implemented several changes to the Morningstar Wide Moat Focus Index construction rules. Among other changes, the index increased its constituent count from 20 stocks to at least 40 stocks and modified its rebalance and reconstitution methodology. These changes may result in more diversified exposure, lower turnover and longer holding periods for index constituents than under the rules in effect prior to this date.
It is not possible to invest directly in an index.

All performance information is based on historical data and does not predict future returns. Investing is subject to risk, including the possible loss of principal.

No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission of VanEck.

© VanEck Securities UK Limited

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