Could The New Morningstar Sustainability Ratings Actually Change Corporate Responsibility?

The Rise Of Sustainable Responsible Impact (SRI) Investing

The recent decades have witnessed a slow but steady rise for an investing approach that goes beyond “just” investing for maximal return, and instead focuses on a combination of both generating long-term competitive returns, while also trying to bring about a positive societal impact.

Early on, this approach of being a “Socially Responsible” Investor most commonly meant avoiding investments into companies whose products were of questionable moral or ethical character – which depending on the perspective of the investor, might have included “sin” or “vice” stocks (e.g., alcohol, tobacco, gambling), weapons makers, or environmentally unfriendly companies (e.g., fossil fuel energy companies).

Over the years, the socially responsible investing (SRI) approach shifted from “just” seeking to avoid companies that were perceived as adverse to the public good, to outright searching for investment opportunities that contributed to the positive, particularly environmental sustainability, leading to a rise of “sustainable investing” approaches that screen proactively for a wide range of positive environmental, social, and governance (ESG) factors.

And in just the past decade, the approach shifted further from merely avoiding negative-impact companies and identifying environmentally sustainable ones, to more proactively seeking out positive-society-impact investing opportunities. Now broadly dubbed “impact investing” – a phrase coined in 2007 by the Rockefeller Foundation – the approach most commonly focuses on investing into new(er) companies trying to tackle private market problems with a balance towards doing both investing good and public good (as contrasted with SRI and sustainable investing approaches, which often focused on allocating capital to existing [publicly traded] companies).

With the continued growth of interest in – and outright dollar flows to – these various forms of socially responsible investing, sustainable investing, and impact investing, the collective SRI space itself has now re-appropriated the “SRI” label from being “Socially Responsible Investing” to “Sustainable, Responsible, Impact” Investing instead, or Sustainable Investing for short.

Notably, there has been a dramatic uptick in interest for sustainable investing in recent years (with the Forum for Sustainable and Responsible Investing estimating that total dollars being invested with some form of sustainability overlay jumped nearly 70% from just 2012 to 2014, and now adding up to more than $6 trillion). In part, the growth seems to be attributable simply to the growing awareness of SRI strategies and their availability. Demographic trends are perhaps beginning to play a role, too, as Millennials in particular are expressing far more interest in sustainable investing than prior generations of investors. Though as sustainable investing is becoming more accessible, some advisors are even finding interest amongst Baby Boomer clients, too.

And this growth has occurred despite the jury still being out about whether SRI investing is imposing a “cost” in terms of expected returns – given that the nature of screening out socially irresponsible companies and focusing on positive impact investing and high-ESG businesses will narrow the available investment universe and “limit” investment choices – with studies finding evidence of both higher and lower returns, and some debating whether periods of underperformance or outperformance of SRI strategies are simply driven by the relative under- or out-performance of underlying conventional investment factors that SRI happens to be more exposed to (e.g., disproportionate tilts towards higher beta or certain sectors).

Arguably, though, one of the greatest challenges to widespread adoption of sustainable investing was/is simply that it’s difficult to construct SRI portfolios, requiring an intensive process of analyzing companies and constructing portfolios from what’s left based on SRI screens and ESG factors. While there are a (growing) number of SRI mutual funds to do this work on behalf of the investor, their binary nature – you either buy an SRI fund, or you don’t – has meant SRI investing decisions were typically all-in or all-out. The tools have been limited to construct portfolios that merely ‘tilt’ in favor of more SRI-oriented companies or funds, without going all-in to dedicated SRI investment managers. Until now.

What Are Morningstar Sustainability Ratings

Earlier this year, Morningstar announced a new “Sustainability Rating” system to score more than 20,000 funds (both mutual funds and ETFs) based on their effectiveness across a wide range of Environment, Social, and Governance (ESG) factors.

The scoring is done by drilling down to the holdings of the fund itself, and looking at each of the underlying companies one by one to identify its company-level ESG score (drawn from Sustainalytics, an independent provider of sustainability research and analytics). Any fund where at least 50% of its total assets are invested in companies covered by Sustainalytics will receive a Morningstar Sustainability Score. And notably, any fund (mutual fund or exchange-traded fund) where at least half of its assets are in companies that Sustainalytics tracks will be scored; Morningstar’s system is not a “pay-to-play” sustainability rating.

The fund’s Sustainability Score itself is a combination of both the (asset-weighted average of) Sustainalytics scores of the companies, with a further deduction made for any companies involved in “controversial incidents” (e.g., environment accidents, fraud, discriminatory behavior, etc.).

The Morningstar Sustainability Score for a fund is then compared to other fund peers in the same Morningstar category, to assign a Morningstar Sustainability Rating. Sustainability Ratings will vary from “Low” to “High” on a 1-to-5 scale, represented by the number of “globes” the fund receives. Thus, a 5-globe fund would have a “high” sustainability rating, a 3-globe fund would have an “average” rating, and a 1-globe fund would have a low sustainability rating. Notably, this means that the Sustainability Score is calculated on an absolute basis (from the ESG scores of the underlying companies), but the Sustainability Rating is based on a (relative) comparison to category peers.

In fact, to ensure a distribution of high and low sustainability ratings in each fund category, Morningstar assigns the globe ratings relative to all the funds in that category. The bottom 10% receive 1 globe, the next 22.5% receive 2 globes, the middle 35% receive 3 globes, the next 22.5% get 4 globes, and the top 10% are 5-globe funds. Notably, because the Sustainability Rating of a fund is applied relative to its category peers, a 5-globe fund in one fund category could actually have a lower absolute sustainability score than a 3-globe fund in another category that has a higher overall average. In other words, Morningstar’s Sustainability Ratings are about the relative sustainability within the category, not at an absolute level across all possible funds.

Potential Uses Of Morningstar Sustainability Ratings

So given that there’s already a universe of sustainable investing funds, including several well-known SRI fund families like Calvert, Parnassus, Domini, and Pax World, what’s the significance of analyzing investments using Morningstar’s Sustainability Ratings? Especially when – as you’d expect and hope – virtually all of today’s recognized SRI funds really do earn 5-globe ratings from Morningstar already.

The problem in large part is that while a number of companies are managed to be socially responsible, and a growing volume of private investment strategies pursue various forms of SRI investing to buy those companies, Morningstar estimates that only about 2% of the fund universe is comprised of SRI funds. Which means, as noted earlier, most investors can either go “all-in” on picking SRI funds, or not… and thus far, few investors have been voting to go all-in on SRI. In the meantime, there’s been little ability to simply ‘tilt’ portfolios towards SRI-favorable investments.

For instance, in the category of large-cap growth funds with strong track records and long manager tenure, both Fidelity Growth Company (FDGRX) and Vanguard PRIMECAP (VPMAX) are reputable players, with 5-star performance from Morningstar (averaging 10.61% and 9.76%, respectively, over the past 10-year market cycle, through the end of August 2016). However, Fidelity Growth Company is a 3-globe fund, while Vanguard PRIMECAP is a 5-globe fund, under Morningstar’s Sustainability Ratings. Which means an investor who was otherwise uncertain of which fund to choose based on its investment strategy and track record alone, might tilt towards PRIMECAP simply because, while it doesn’t have an explicit sustainability investing mandate, it is nonetheless more sustainably invested. Similarly, in the large-cap value space, both MFS Large Cap Value (ILVAX) and American Century Equity-Income (ACIIX) have strong 5-star performance track records from long-standing fund managers… but the MFS fund only receives 3 globes, compared to American Century’s 5-globe Sustainability Rating.

Notably, because the Sustainability Ratings are all scored relative to other funds in the category, it’s feasible for the investor to create a relatively more sustainable portfolio (from the same target asset classes or categories) without concentrating the fund into or out of certain industries and sectors (which can otherwise happen, given that certain sectors like energy contain a disproportionately high number of companies with potentially adverse environmental impact). In other words, rather than choosing from a small subset of SRI funds, which potentially have certain sector concentrations, it’s now possible to choose the most SRI-friendly from otherwise “standard” diversification choices amongst large-cap growth, large-cap value, mid-cap, etc. (Though notably, many small-cap companies are too small to be rated by Sustainalytics, and thus many small-cap funds have no sustainability rating from Morningstar.)

In addition, the reality is that while Morningstar’s Sustainability Ratings do affirm that most SRI-focused funds really are implementing sustainable investing strategies (i.e., they really do score as 5-globe funds), their absolute sustainability score in many cases is not actually any higher than some not-specifically-SRI funds! For instance, Vanguard PRIMECAP (VPMAX) actually has a higher sustainability score (53) than the Domini Social Equity Fund (DSEFX) or Parnassus Core Equity (PRBLX) (which both have a sustainability score of 50).

In other words, the Morningstar Sustainability Ratings make it possible to either identify the subset of otherwise-desired funds that also have high sustainability ratings (e.g., 4- and 5-globe funds), or alternatively to screen out especially poor sustainability funds (e.g., those with only 1 or 2 globes), without being forced to “pick an SRI fund” or not. This makes it feasible for the advisor to tilt the portfolio towards the funds that choose more sustainable companies in each category, and in some cases to even pick “non-SRI” funds that are just as sustainable as those with a sustainability mandate.

In addition, because Morningstar also includes the raw Sustainability Score (in addition to the category-specific Sustainability Rating), it is also possible to craft a portfolio that does target a high absolute level of sustainable investing as well (e.g., just picking the highest sustainability scores, regardless of fund category or style box).

How Morningstar Sustainability Ratings Could Move Markets

Ultimately, Morningstar Sustainability Ratings are a big deal, because it shifts sustainable investing from a “niche” style that requires specialized funds and managers, to one that is more accessible to a far wider range of prospective investors. After all, the reality is now that almost anyone can implement at least a sustainable investing “tilt” to their portfolio. Just start screening out the 1-globe and 2-globe funds, or lean towards the 4-globe or 5-globe funds, anytime the available investment choices are otherwise close.

In fact, it’s not hard to imagine new investing platforms or solutions that could crop up, to further leverage sustainability ratings. Advisors could easily roll out and advertise “sustainable” versions of their investment strategies, implemented by screening out low-globe funds in the portfolio. A new crop of “sustainable investing” asset managers could appear, who don’t pick the individual ESG-friendly companies (as most SRI managers do today), but instead assemble portfolios of sustainable investing (high-globe) funds (which perhaps will become a new category of managed-ETF strategies?). And third-party platforms may emerge to further leverage sustainability ratings to craft portfolios – for instance, Motifs comprised of high-globe funds, or a Quantopian strategy that trades ETFs based on their sustainability ratings (and how they change over time). Simply put, it’s far more feasible to craft sustainable investment strategies and algorithms to run them, once there’s a “standardized” scoring system to use.

And with the potential for this to be done systematically, and by an increasing number of investors – given the demographic trends towards Millennials and their commonly expressed preference for more sustainable investing strategies – it’s actually possible that Morningstar Sustainability Ratings could begin to move markets. After all, when in the aggregate a material number of investors shift their fund preferences towards more sustainable-investing-oriented fund managers (whether part of their stated investment objectives or just an outcome of them), and those managers in turn have more capital to deploy (to companies that score favorably on ESG factors), then socially responsible companies actually end out with better access to capital markets and an incentive to engage in better corporate governance.

In other words, when Morningstar Sustainability Ratings make it easier for investors to allocate capital towards companies that advance the public good and away from those that do not – as measured and “scored” by Morningstar and Sustainalytics – it allows capital markets to exert a force on corporate decisions in a positive manner (and without trying to ‘force’ it with regulation). And lest anyone question whether a “simple” Morningstar system could ultimately have that much impact on the decisions of managers, just look at how benchmarking fund manager behavior to Morningstar style boxes has impacted the behavior of those managers over the past several decades. Be careful not to underestimate the consequences of how having a clear “scoring system” can impact investor (and manager) behavior! (Though notably, a near-term rise in sustainable investing could actually trigger an over-concentration of dollars into a subset of more socially responsible companies, potentially distorting their market prices in the near term?)

Of course, all of these outcomes still rely on a desire of investors to actually pursue more sustainable investing strategies, when the evidence of whether SRI actually enhances long-term returns is still mixed. Nonetheless, the reality is that sustainable investing doesn’t actually have to increase returns for investors to decide to adopt it. If sustainable investing merely doesn’t hurt returns – which appears to be supported by a growing volume of research – while also accomplishing the secondary goal of improving the public good (in non-financial terms), that’s still a plus for investors who are concerned about such issues. Not to mention the subset of investors who believe that sustainable investing is literally more sustainable – financially and non-financially – in the long run, and will invest that way because they believe the long-term outcome will be more favorable, even if the statistics can’t definitively prove (or disprove) it yet.

And so the question remains: with Morningstar Sustainability Ratings making it easier than ever for investors to tilt portfolios in favor of sustainable investing, and investors in general (and Millennials in particular) expressing more interest in sustainable investing strategies, are markets on the cusp of a transition where pursuit of more sustainable companies will actually begin to influence capital markets and hold businesses more accountable for their environmental, social, and governance impacts?

So what do you think? Are you using the Morningstar Sustainability Ratings as a screen or search criteria when constructing portfolios? Are you thinking about doing so in the future, now that the ratings are available? What do you think the long-term impact will be? Please share your thoughts in the comments below!