Morningstar Sustainability Rating: Impacts For Advisors And Corporations

Wednesday, March 09, 2016 17:44
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Morningstar Sustainability Rating: Impacts For Advisors And Corporations

Tags: ESG | investing | investment management | Morningstar | mutual funds | sustainability

Morningstar, a leading provider of independent investment research, is known for evaluating financial results – risk/return – and publishing the Morningstar Rating™, commonly known as the “star” rating, to measure the past performance of funds. Three stars represents an average risk/return rating compared to a peer group of similarly invested funds; four or five stars are above average while one or two stars are below average.

 

Although Morningstar’s star ratings do not consider every aspect of each fund’s financial profile, it is an indicator that is taken quite seriously by investors and advisors. Analysts also assign the qualitative Morningstar Analyst Rating™, which represents Morningstar’s conviction in the fund’s ability to outperform on a risk-adjusted basis over the long term.

 

Now, Morningstar has introduced the Morningstar Sustainability Rating™. 

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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.

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