Up until recently, it has not been an easy task for investors to ascertain whether the funds they own uphold the best sustainability practices. This is because investors have not had a standardised way to assess how companies held by a fund are managing environmental, social, and governance (ESG) risks.
The rating gives investors a way to see how well, if at all, a sustainable fund is living up to its name
In most cases, sustainable investors have typically sought funds with a label – an intentionally stated mandate. But that meant they had to rely on fund managers’ individual interpretations of sustainability.
Rules of Engagement: A Hodgepodge
This poses several issues. In the first instance, intentional ESG mandates can vary widely in their parameters across funds, giving the manager considerable scope for interpretation. To give just one example, some ESG managers are willing to invest in firms that do not yet exhibit desirable ESG practices, with a view to changing the firms for the better via close engagement with boards and management teams. It is thus not necessarily always clear whether your choice is a “sustainable” fund or one that is “on-the-journey” to becoming sustainable.
Some fund groups have invested in specialist governance committees who take part in active corporate engagement and conduct valuable research on the way companies handle ESG issues and controversies. But the influence that these committees have on the trading decisions of fund managers is often limited. This accentuates the subjective nature of engagement and the heterogeneous ESG approaches.
It is therefore difficult for investors to understand objectively the type of exposure they are getting from a given ESG mandate, and how it might compare to other choices in the market. Further, in narrowing their choices to intentional ESG funds, investors are left with a severely restricted opportunity set. Funds with dedicated ESG mandates comprise a very small portion of the overall fund universe. Given the many ways that such mandates are open to interpretation, you could argue such an extreme sacrifice of investment choice is not necessary.
Comparing Funds in a Standardised Way
To help investors understand the sustainability profiles of their fund holdings on an objective basis, Morningstar has launched a new sustainability rating that rates a fund based on how well each of the companies it owns lives up to a set of defined ESG criteria. The rating gives investors a fresh perspective on how well the underlying companies in a fund are doing on a sustainability basis relative to their peers, and also helps them compare funds across categories and relative to benchmarks. The Morningstar Sustainability Rating is based on ESG company research from Sustainalytics, a leading provider of ESG and corporate governance ratings and research.
The rating gives investors a way to see how well, if at all, a sustainable fund is living up to its name and provides a snapshot of its manager’s approach to ESG. Notably, the rating also helps expand the universe of funds that could be acceptable to a sustainable investor beyond those that have an explicit ESG mandate, highlighting funds that score well on sustainability across different sectors, regions and asset classes. As such, it helps expand the investable universe in ways that should allow investors to more robustly diversify, fill out their portfolio allocations and more easily achieve their investment goals – without sacrificing a desire to do so in a sustainable fashion.
A version of this article appeared in Investment Adviser magazine
