Through the looking glass – two new ESG fund ratings systems

Written by Lisa Stanley Mann on 21st March 2016

In a significant development for third-party fund ratings and analysis, global investment research provider Morningstar and governance research and ratings provider MSCI ESG Research, have each developed their own capability to rate investment funds on Environmental, Social and Governance factors.  In recent weeks, both have rolled out their service each covering about 20,000 mutual funds and exchange-traded funds (ETFs).

The Morningstar Sustainability Rating, “a new lens for sustainability analysis”, effectively plugs-in and aggregates company reports from Sustainalytics to evaluate mutual funds and exchange-traded funds (ETFs) on the level of ESG Risk exposure at portfolio level.  Sustainalytics analyses and scores companies on how well they are managing their ESG risks and opportunities.

MSCI ESG Fund Metrics, a “natural extension” of MSCI’s ESG company ratings and research, will give each fund an ‘ESG Quality Score’, a peer group percentile rank and individual E- S- and G- scores on the basis of ESG characteristics of portfolio holdings and it will rank or screen funds based on factors including sustainable impact, values alignment and ESG risks, including carbon footprint.  Clients will be able to look at over 100 Metrics on funds to evaluate the ESG attributes of their portfolio in three categories: sustainable impact, values alignment and risks.

A paper by MSCI to accompany the launch, ‘Fund Transparency: Exploring the ESG Quality of Fund Holdings’, made a number of interesting findings:

–                 Government bond and European equities funds scored highest on ESG Quality, while small‐cap US, emerging market equity, and high yield bond funds scored lowest;

–                 146 diversified US equity funds had over 10% exposure to companies owning high‐impact fossil fuel reserves like coal or oil sands;

–                 It found just over 1,000 US equity funds – with $825bn in net asset value – that are virtually ‘fossil fuel free’, though very few if any were marketed as such;

–                 Over 3,000 funds across asset classes, representing nearly $1.8trn in net asset value, were identified as having significant exposure to sustainable impact themes (like alternative energy, health care, nutrition), but only 14% of these were identified as specialized thematic or sector funds.

As these points highlight, an ESG funds ratings service was probably overdue in that it will allow those investors who want to incorporate ESG risk factors into the management of their individual savings, investments and retirement pots the tools to do so in a much more effective manner.

Given the various possible ways of interpreting and approaching the area of responsible or sustainable investing, it is also an important step in providing greater objectivity and clarity, and giving investors the ability to compare funds’ credentials.

These services are a response to demand and a gap in the market, but may equally drive interest of itself; Morningstar’s service will reach a global audience of 250,000 advisors and 10,000 institutional investors.

Morningstar Methodology

Effectively the rating capability combines the Morningstar platform of funds data takes with Sustainalytics company ratings. For each fund analysed, the Sustainalytics ratings for each of the underlying holdings will be aggregated for an overall score.

Provided there are a minimum of 10 funds in a category with an ESG score they will be rated against their peer group as follows:

The calculation is a two-step process. First, each fund with at least 50% of assets covered by a company-level ESG score from Sustainalytics receives a Portfolio Sustainability Score: an asset-weighted average of normalized company-level ESG scores with deductions made for companies involved in controversial incidents, such as environmental accidents, fraud, or discriminatory behaviour.

Funds will then be given a rating is the Portfolio Sustainability Score relative to at least 10 category peers, assigned in a bell curve distribution.  Funds receive Sustainability Ratings described as Low (Bottom 10%), Below Average (Next 22.5%), Average (Next 35%), Above Average (Next 22.5%), and High (Top 10%).

Morningstar assigns ratings to all funds that have more than half of their underlying assets rated by Sustainalytics, not just funds with explicit sustainable or responsible investment mandates.

Morningstar’s initial analysis of the ratings indicates that funds with explicit sustainable or responsible mandates are generally practicing what they preach. Nearly two out of three such funds received the highest ratings, more than double the percentage of funds with Sustainability Ratings overall. It’s important to note that funds with explicit sustainable or responsible investment mandates comprise only about 2% of the fund universe.