22 MAR

2016

Fund analysis and rating firm Morningstar now incorporates ESG (environmental, social and governance) criteria in its fund ratings. Such an initiative is clearly a step in the right direction and is highly commendable. As Morningstar put it, "Investors need better tools to help them determine if the funds they currently hold or are planning to invest in reflect best practices in sustainable development."

This type of decision-making tool is valuable for socially and environmentally conscious investors, allowing them to weigh their investment choices against ESG criteria. It’s also useful for the asset management industry, in that truly effective ratings can be used to detect and even weed out "light" SRI investment products, i.e. funds subjected to a green-washing process and which in reality do little – if very little – to observe ESG criteria.

20,000 ESG-filtered funds

For the big launch, the new Morningstar ESG rating covers an investment universe of 20,000 actively or passively managed funds (ETFs). To obtain the "Morningstar Sustainability Rating", at least 50% of a fund’s constituent investments must be companies rated by Sustainalytics, an independent ESG and corporate governance research provider. Next, each fund under review is compared to its peers and given a score of one to five globes, with five globes being the highest rating.

Of course, even with the methodology established, everyone knows that ESG criteria can be a bit slippery to grasp considering the sheer number of often complex approaches out there. That’s why it’s important to be rigorous in interpreting the conclusions of ESG analyses and to be consistent in comparing and contrasting several different funds.

Avoiding interpretation bias

The way we see it, requirement No. 1 is to observe a real balance between the different ESG criteria for a given class of funds, just as "Best-in-Class" fund managers do when selecting the best companies from an SRI standpoint in each sector. Since each fund has its own sector specifications, it is critical to steer clear of interpretation bias, which is just what Morningstar set out to do. Its ESG scores are determined within each sector; that way, sector-neutral funds (such as certain quant or index funds) are not penalized .

Nor does the Morningstar approach penalize funds that do not invest in companies subject to reputational risk. In fact, these funds are fairly well-positioned overall, though somewhat dispersed in the rankings. Here, we’re referring to funds that rule out companies due to major breaches (or controversies) of international standards in human rights, labor rights, environmental protection and corporate governance/anti-corruption based on principles such as those set forth in the United Nations Global Compact.

Pushing the envelope

Why not take it a bit further, while we’re at it? For example, by providing investors not just with a fund’s rating, but also the ratings assigned to its benchmark indexes, they’ll be able to gain a better appreciation of efforts to improve ESG quality and the ESG profile of the funds in which they’re thinking of investing.

Doing so would highlight the lack of transparency in certain asset classes, such as emerging equities. Investors would thus become fully aware that this is an investment universe with fewer ESG standards, more lenient regulations and more restricted access to information – a problem often accentuated by the language barrier.

As the saying goes, the perfect is the enemy of the good. The goal should not be to create an ESG filter that is overly complicated or to try to cover every conceivable angle. Nevertheless, there are myriad SRI practices, and investors who are rightly concerned about ESG criteria applied to companies are also right to be concerned about those applied to investment funds. For instance, nothing is currently said about a fund’s active participation as a shareholder, in terms of exercising its voting rights or maintaining a dialogue with companies for example. A simple “yes it does or no it doesn’t” would suffice, as far as that goes.