RI Interview: Morningstar CEO Kunal Kapoor on sustainability ratings

Research firm addresses criticism of new ratings

It has been more than a year since US funds rating giant Morningstar launched sustainability ratings (now for 34,000 funds) globally and in the next few months it says it will publish in-depth details of how each fund score is decided.

It follows criticism from some in the sustainable investment community towards the ratings. At its conference in Amsterdam in March, a session on the ratings – led by the firm’s Head of Sustainability Steven Smit – drew tough questioning.

Broadly, Morningstar’s sustainability ratings have two components. First a Morningstar Portfolio Sustainability Score is assessed from a fund’s holdings. Then there’s a Morningstar Sustainability Rating that compares it with other funds in their category, such as Global Emerging Markets Equity.

The Morningstar Sustainability Rating is depicted with globes with five globes being the highest rating and one the lowest.

One conference attendee questioned the sense of a Dutch fund in isolation (the Morningstar Portfolio Sustainability Score) being more sustainable than a Chinese equity fund, but the Chinese equity fund having more globes for the Morningstar Sustainability Rating – the comparison with its peers.

In response, Smit said the firm published on its website the raw underlying score.

“If you pay attention, the Chinese equity fund has 32 (the Morningstar Portfolio Sustainability Rating) and four globes (the Morningstar Sustainability Rating), and the Dutch fund has 67 and two globes. It isn’t a solution for all – investors need to keep using their head – there are a number of metrics.”

The company executives were asked whether the globe ratings should be tracked over time as funds could appear sustainable as they are exposed to certain companies, “but this can change quickly. Maybe you can quickly switch globe ratings and look over time.”
Smit said it was testing for that tracking over time, among other things, and if it made sense it may take it forward. This, and publishing details of how Morningstar arrives at its fund scores, are just some of the developments it is looking to make.

In an interview with Responsible Investor, Smit and Kunal Kapoor, the relatively new CEO of Morningstar, appreciate there has been criticism of its sustainability ratings but Smit insists that the “applause has been way louder”.

He says: “Eight out of 10 asset managers we talk to think this is a very meaningful and necessary breakthrough. Before there was no light on the sustainability lens and there was no way of insight. The portfolio holdings are the single best indicator because it really tells what the fund is doing.”

Morningstar describes its sustainability ratings as a measure of how well the holdings in a portfolio manage their ESG risks and opportunities relative to their peers.

The scores are based on data from ESG research house Sustainalytics and reflect elements such as company policy and performance on areas including carbon footprinting and gender diversity.The ratings also track ESG-related controversial incidents. In a CFA article Sustainability Scores for Investment Funds, Jeroen Bos, Head of Equity Specialities at NN Investment Partners, writes that this means the higher the ESG scores of the companies in an investment portfolio, the higher the portfolio’s sustainability score.

The investment fund is then compared with its peer group of funds from the same Morningstar category and given a ranking within this group of high, above average, average, below average, or low – the globe ratings.

But, the methodology has been criticized for limitations by sustainability fund managers such as Impax and Wheb Asset Management.

Andy Howard, Head of Sustainable Research at Schroders, called it “painting by numbers”.

Bos shares this sentiment, saying it causes a bias to larger companies as they have the resources to formalize ESG ambitions and that it focuses on the policies companies have in place rather than on the products or services they provide. This means that even in sectors such as tobacco or controversial weapons a fair number of companies have high ESG scores – meaning owning these help improve a fund’s sustainability ratings.

Bos also criticizes the peer comparison saying a renewable energy fund could have a low or below-average sustainability score relative to other renewable energy funds, while a traditional energy fund might score above average or high relative to other traditional energy funds.

Kapoor says: “First of all it’s really important that when you look at our ratings that there is an acknowledgement that they are groundbreaking. They are the first of their kind. They are doing something which has not has been done before and while I think people are right in terms of having expectations that the ratings will evolve as we have more data, as we test things.

“It’s a bit like missing the forest for the trees when you say the rating is not perfect on day one because certainly the intent of the rating is to start to provide the information that people need and then evolve.

“You can look at any rating and poke holes in it but if you look at what we have done – we have taken a very complex set of information and delivered it in a way that people can consume it, relate to it and begin making decisions based on it.”

He adds that the data is not to be used on a standalone basis describing it as “one leg of a stool”.

Smit shares this sentiment, he says it is 1.0 version and will evolve, saying the ratings initiative “adds credibility as this part of the market was getting greenwashed too much.” He says that the CFA Society Sweden has awarded Morningstar its ESG award for its sustainability ratings.

Drilling down to the ratings’ methodology, Smit says it is a misconception that its sustainability ratings are based on companies’ policies.

“Sustainalytics, MSCI, Vigeo EIRIS – those specialized researchers of companies on sustainability are not just taking policies from companies as an input for the rating, they are also taking performance into account.
For example: the actual C02 output of the company in relation to the sector.”

He also stresses that along with performance the sustainability ratings take into account controversy. “That’s the actual proof – where it goes wrong. So part of it is policy, part of it is performance – how are they doing with their output like recycling, water use. If you look into a Sustainalytics report you will see 70 KPIs [Key Performance Indicators] they are using. It’s not only policy.”

On the criticism of bias to large companies with bigger budgets, Smit says that Sustainalytics rates small-caps in a different way and they don’t have to go as deep as providing information as large-caps. He adds that as funds are rated like with like, which corrects for small-cap bias or US bias.

But the sustainability ratings will evolve. This will involve publishing in-depth details on how Morningstar decides the ratings for each fund. It will also work with asset managers and SIFs on reporting. Smit explains: “We are members of different SIFs around the world including UKSIF and the PRI. So these organisations and the members have an abundance of knowledge and we want to tap into that because we don’t know everyone and we think we have a joint responsibility with the industry to bring this to investors in the best possible way. If they can help us with specific insights and knowledge and we are happy to tap into that.

“When we developed the initial sustainability ratings we consulted with about 10 outside organisations– not just asset managers, but private banks and university professors.”

Smit says Morningstar also has an internal research council and he stresses the importance of its relationship with Sustainalytics: “We have a lot of ideas and where it’s possible – technologically, data, research-wise – we will not hesitate to make improvements and we want to vet that with a number of outside institutions.”Smit says it is testing for a number of different things including using multiple portfolios instead of one to assess the sustainability rating.

“That is, for example, to take multiple portfolios for one fund, e.g. the ones over the past 6 months so that the rating could take into account more information and a longer time period.

Another area Morningstar is looking at is fund categories. Smit explains: “The globe ratings are assessed within categories of comparable funds to get peer-to-peer comparisons. Some categories contain a smaller set of funds and we are looking to see if combining categories that contain funds with quite similar investment focus, leads to a more telling distribution of globes.”
But Smit says: “We have to be really convinced that it is an improvement and we are also quite new with this rating so we don’t want to radically change it – we will gradually evolve it and I hope within 2017 and we can bring in new elements.”
Morningstar also plans to bring in a service where clients can screen out funds for elements like tobacco or weapons. Smit explains: “We feel that making exclusions or punishing certain involvements is a value judgment that Morningstar cannot make on behalf of its investors.
But it matters very much so we should give transparency into that element and build it in our research platform Morningstar Direct.” Its aim is to launch in the summer and will allow investors to screen out funds or say they don’t want to have funds that invest more than a certain threshold in a certain product.