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The Morningstar Sustainability Rating

The new Morningstar Sustainability Rating for funds gives investors a new way to evaluate funds based on the sustainability profile of their underlying holdings

Morningstar 17 March, 2016 | 9:11AM

At Morningstar, our mission is to create tools that help investors make sound decisions so they can reach their financial goals. During the past 30 years, innovations like the Morningstar Rating, the Morningstar Style Box, the Morningstar Category, the Morningstar Stewardship Grade, and the Morningstar Analyst Rating have given investors the world over the ability to analyse, compare, select, and monitor mutual funds and exchange-traded funds.

Our Morningstar Sustainability Rating for funds follows in that tradition, giving investors a new way to evaluate funds based on the sustainability profile of their underlying holdings.

Sustainability is a big deal to a lot of people today. In survey after survey, citizens express concern about climate change, environmental issues, the ways companies treat their workers, and corporate social responsibility. In the investment world, these concerns are often referred to as environmental, social, and governance, or ESG, issues. More and more investors are interested in seeing ESG concerns addressed in their portfolios, particularly women and younger investors.

For many, their interest is values-based. They want to invest in companies whose activities reflect their sustainability concerns. For others, including many asset managers who now routinely incorporate ESG factors into their investment processes, the interest is value-driven. Given the increasing recognition that sustainability issues can affect a company’s bottom line, it simply makes sense to consider ESG in a thorough investment process, especially one with a long-term perspective.

Until now, investors have lacked the tools to evaluate the sustainability performance of funds.

Their choices have been limited to a relative handful of funds that explicitly hold themselves out as having sustainable or “responsible” investment objectives. These funds, known as socially responsible investment, or SRI, funds historically have relied on exclusionary screening techniques coupled with active ownership; proxy voting, filing or cosponsoring shareholder resolutions, and direct company engagement. Today, most SRI funds also incorporate ESG factors into their selection processes.

SRI funds may fit the needs of some, but investors interested in sustainability face two challenges. First, there simply aren’t very many of these funds. They comprise only about 2% of the fund universe globally. Some SRI funds are good performers, but others haven’t established strong performance records, further reducing the viable options. Retirement plans frequently lack such options altogether. The second challenge is that there has been no easy way to evaluate independently how well these funds are incorporating sustainability concerns.

The Morningstar Sustainability Rating helps investors address those challenges and put sustainable investing into practice. By using the ratings, investors can independently evaluate whether an SRI fund is living up to its mandate by holding companies that uphold best sustainability practices. Moreover, because Morningstar applies the Sustainability Rating to any fund for which there’s sufficient underlying holdings data covering approximately 20,000 funds in total, it makes it easier for investors to look beyond SRI funds to consider conventional funds that hold companies that do well on ESG metrics.

In sum, the Morningstar Sustainability Rating responds to investor demands for a more reliable, objective way to evaluate whether their investments reflect best sustainability practices.

How the Rating Works

The Morningstar Sustainability Rating is a measure of how well the companies held by a fund are managing their ESG risks and opportunities when compared with similar funds. We use company-level ESG data from Sustainalytics, a leading provider of ESG ratings and research, to calculate the rating. All funds with at least 50% of their assets in firms that have been assigned company-level ESG ratings by Sustainalytics will receive a rating.

We assign a fund’s Sustainability Rating in two steps: First, we derive a Morningstar Portfolio Sustainability Score. This score is an asset-weighted average of a portfolio’s normalised company-level ESG scores with deductions made for the controversies in which the portfolio’s holdings are currently involved. (For further information on Sustainalytics’ scoring methodology, refer to the Morningstar Sustainability Rating methodology document. We normalise Sustainalytics’ company ESG scores to make them comparable across industry peer groups, which is necessary when scoring diversified portfolios.

Next, we sort funds into five normally distributed groups by comparing a fund’s Portfolio Sustainability Score with that of its Morningstar Category peers.

Using the Sustainability Rating

Investors, and those helping them make decisions, can use the Portfolio Sustainability

Score to evaluate how well the companies in a portfolio are managing their ESG risks and opportunities relative to their industry peer groups. Scores above 50 indicate that, on average, a fund’s holdings place in the top half of their industry peer groups. Investors can use the Sustainability Rating to evaluate a fund relative to other funds in the same Morningstar Category.

They can use it to evaluate how well the funds they already hold are applying best sustainable investing practices or to evaluate prospective investments through an ESG lens. They can also use the rating to assess how well SRI funds are living up to their mandates. Finally, the rating and supporting analytics afford investors a wealth of data that they can sift through in drawing their own conclusions about the investing payoff—in financial risk and reward terms—of incorporating sustainable principles into a portfolio.

Conclusion

Our Sustainability Rating is not the last word on sustainability, but an important first step toward providing investors with better tools to evaluate and compare funds based on sustainable investing principles. The rating helps investors answer fundamental questions such as, How well are the companies that my fund owns managing the risks and opportunities associated with the sustainability challenges they face?

And the rating does so objectively and robustly, leveraging fund holdings data, calculating portfolio scores, and comparing funds in a uniform, reliable way. It is an advance that should help sustainability-minded investors generate better outcomes when measured in terms of ESG opportunities and risks.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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