What do Morningstar’s new ESG ratings mean for investors?

Green-Shoots-Emerging-Growth-700.jpgSustainable investing is no longer a niche activity. New generations of investors around the world are looking for ways to learn whether the investments they own reflect the best sustainability practices, because it aligns with their values or perhaps they simply believe it can lead to better investment outcomes.

Until now, though, there hasn’t been a way for investors to assess how well the companies held by a fund are doing managing the environmental, social, and governance (ESG) risks and opportunities they face in their businesses, nor a way for investors to compare funds on that basis.

To date, ESG research has largely taken place at the company level and been made available to asset managers and large institutional investors to help them incorporate ESG issues into their investment process.

Investors wanting to evaluate funds on these same sustainability factors, however, have had no easy way to do so. They could seek out funds with an intentional sustainability mandate, but ultimately had to rely on claims made by asset managers regarding their approach to sustainability. That’s why Morningstar plans to introduce a Sustainability Rating for funds and other ESG metrics, which will provide investors with a set of tools to view and analyse investment portfolios through an ESG lens.

How should investors use them? The new Morningstar Sustainability Rating and ESG metrics are based on actual portfolio holdings and apply to all funds; they are not limited to funds with explicit sustainability objectives. While some investors may prefer such funds, those fundamentally committed to sustainability objectives comprise only about 2 per cent of the investing universe. Most investors who are interested in sustainable investing thus own conventional funds.

Using our new ratings, investors may discover that the funds they own are not doing well enough on a sustainability basis and will actively seek out funds that are more fundamentally committed to sustainable investing. Others may find that the existing funds in their portfolios score in a range that is acceptable to them, particularly given the fund’s overall quality and performance record. Still others may use the information to dig deeper into whether, and how, a manager is considering ESG issues in the investment process.

While we recognise that different managers may consider ESG factors and incorporate them in different ways, our sustainability rating measures how well the companies in a portfolio are managing their ESG risks and opportunities relative to their peers within the same industry. We do not base the ratings on exclusionary screening of specific companies, products or industries. We base them on company-level ESG analytics from research provider Sustainalytics.

Our sustainable investing metrics will provide investors with a fresh perspective they can use to evaluate how well the companies in a fund are doing on a sustainability basis, and to compare funds across categories, relative to benchmarks, and, eventually, over time based on ESG factors. The sustainability ratings can serve as an initial screen for investors interested in sustainability and ESG, and as a useful starting point for investors wanting to know more about a manager’s investment process and how it relates to sustainable investing. We think it is a key link for turning the widespread interest in sustainable investing that we see today around the world into actual investments.

Jon Hale is head of sustainability research at Morningstar