Morningstar Sustainability Rating: Impacts For Advisors And Corporations
This rating measures how well the holdings in a fund are managing their environmental, social, and governance (ESG) risks and opportunities relative to their category peers. The rating will apply to all funds globally based on quality ESG research provided by Sustainalytics (the leading independent global provider of ESG data) and is calculated based on company-level ESG scores and company involvement in ESG-related controversies.
It should be noted that sustainable investing differs from socially responsible investing in that sustainable investing is a long-term oriented investment process that incorporate ESG factors, while socially responsible investing is a traditional values-based approach that uses exclusionary screening to avoid exposure to certain types of products or industries.
Factors considered for sustainable investing are shown below.
Environmental Issues |
Social Issues |
Governance Issues |
Climate Change and carbon emissions |
Product safety |
Board composition |
Air/water pollution |
Data protection/privacy |
Audit committee structure |
Energy efficiency |
Gender and diversity |
Executive compensation |
Water scarcity |
Employee engagement |
Lobbying |
Waste management |
Supply chain management |
Political contributions |
Deforestation |
Labor standards |
Bribery and corruption |
Exclusionary factors screened out in socially responsible investing can include:
Products |
Energy/Chemicals |
Weapons |
Tobacco products |
Nuclear power |
Controversial weapons |
Alcoholic beverages |
Thermal coal |
Military contracting |
Gambling |
Pesticides |
Small arms |
Palm oil |
Animal testing |
|
The demand for ESG investing is growing, with the market currently approaching $45 trillion in AUM. Further evidence of this demand is the strong growth of the United Nations backed Principles of Responsible Investment.
The Morningstar Sustainability Rating is calculated as follows:
1) Morningstar fund data is used as input for Sustainalytics’ security level research, producing:
a. a Company ESG score (0 to 100) and
b. a Controversies score (1 [low] to 5 [high])
2) The fund Portfolio Sustainability Score is calculated based on an asset weighted roll up of company-level ESG scores with deductions made for holdings with controversies.
a. Sustainalytics’ ESG scores are normalized across sectors.
b. Company level analytics apply to stock and corporate bonds.
c. To meet the scoring threshold, 50 percent of AUM must have ESG scores.
3) The Portfolio Sustainability Rating is based on the fund’s sustainability scores relative to other funds within the same Morningstar category.
a. At least 10 portfolios in a category are required to receive a rating.
b. The Morningstar Sustainability Rating distribution is as follows:
Score |
Percent |
Word Label |
5 |
Top 10% |
High |
4 |
Next 22.5% |
Above Average |
3 |
Next 35% |
Average |
2 |
Next 22.5% |
Below Average |
1 |
Bottom 10% |
Low |
What does this mean to advisors? I believe it means that we must consider these ratings when choosing portfolio holdings. Companies with higher ESG ratings are likely to have a lower risk of liability claims which could translate into higher long-term earnings. Also, our clients will be concerned about these ESG ratings just as they are the Morningstar funds ratings. If they aren’t concerned right away, they will be as the ratings becomes better known.
In looking at my own firm’s current preferred funds, the majority of them were ESG-rated. Although some funds were rated “above average”, other funds ranged from “average” to “low.” Since we are currently in the midst of our annual investment review, we will surely consider these ratings in our upcoming decisions.
In my opinion, the Morningstar Sustainability Ratings will eventually have an impact on how corporations do business. As more investors and their advisors shy away from funds with low ratings, the underlying low-rated companies will attract less investment dollars. The ultimate solution for these companies is to up their game in ESG areas. This could lead to a major shift in how companies do business.