Taking a closer look at Morningstar’s updated sustainability ratings

Over two years have passed since US fund giant Morningstar launched its sustainability ratings. Many in the responsible investment community bristled at the ratings when they arrived on the scene, expressing fundamental concerns over their methodology – chiefly, the nature of the underlying data behind them, provided by Sustainalytics, the ESG research house part owned by Morningstar itself.
But the company’s CEO, Kunal Kapoor defended the ratings against the backlash at the time, stressing their evolving nature.
Last month saw the next stage in that evolution, as the NASDAQ-listed firm announced four amendments to its methodology, which, in short, see funds now rated over a one-year period rather than being based on the most recent portfolio, and relative to broader global peer groups.
Morningstar’s Director of Sustainability Research, Jon Hale, told RI that “intentional ESG funds” are likely to be the greatest beneficiaries of the changes, which, he said, should produce greater “consistency in scores”.
But will critics in the responsible investment community be convinced by the changes?
The “main issue” has never been whether funds’ holdings were rated over 12 months or not, says Damien Lardoux, Head of Impact Investing at London based boutique wealth manager EQ Investors. It is, and remains, he says, that “they are looking at ESG and focusing on disclosures, rather than on what companies are doing”.
Similarly, Andrew Howard, Schroder’s Head of Sustainable Research, who previously referred to such ratings as “painting by numbers”, tells RI that “nothing particularly has been changed” as a result of the amendments.
But RI has learned that one consequence of the changes, namely the removal of the ‘Ecology’ sector as a rating category, might prove to be significant.
Hale tells RI that the funds previously rated in the ‘Sector-Ecology’ category – an arguably slippery sub-group for funds focused on sustainability, which had thrown up some contentious results – will now be “rolled up” into either the Global Equity Large Cap or the Global Equity Mid/Small Cap grouping, depending on their portfolios.
This is due to Morningstar moving away from comparing funds based on where they were domiciled, and will mean that funds will be compared across larger peer groups (with a new minimum of 30 funds), as the global system compares like funds – for example, emerging market equities – irrespective of where they are based.
Hale concedes that the previous system had resulted the creation of small peer groups – such as the Ecology sector – which ran the risk of “creating distinctions without difference” when funds were ranked against each other under Morningstar’s ‘five globe’ scoring system.
51 out of 52 of the funds previously included in the Sector Ecology group now score a sustainability rating of three globes or more under the new rating system. Under the Ecology grouping it was just 36.
Hale acknowledged that the good scores of some of the funds in the Ecology grouping weren’t reflected in the ratings they received because they were in a “tough comparison category”.
This led to concerns that these funds might be perceived to be less sustainable when compared to more highly-rated funds in less competitive groups that aren’t dedicated to ESG.
“We looked at the Ecology sector and we realised that people like Impax Asset Management and Wheb Asset Management, who invest in good companies whose core products and services are making a positive impact, were getting an average rating,” explains Lardoux.Wheb’s Managing Partner, George Latham describes the changes to the Ecology category as a “partial resolution”, but agrees that it still doesn’t solve the underlying issues with the methodology.
Critics of these types of ratings are often irked by what they see as the inappropriate use of the term “sustainability” when, they argue, the ratings focus on the ESG practices of a company and not their actual impact.
Latham tells RI: “If they called it an ESG rating, which it is, based on an ESG best-in-class approach, that would make some sense but to call it a sustainability rating, which is a bigger statement about the fund, is something else because ESG only captures part of the story”.
Ray Dhirani, Head of Sustainable Finance and Green Economy at WWF-UK, also expresses his concern about the conflation of ESG and sustainability, saying that – to be meaningful – “[such] metrics need to encapsulate the actual impact on people and the planet”. “What a company does is perhaps more important than how it does it”, he says.
Hale acknowledges that criticism that the ratings rely on backward-looking ESG data is something that “everyone [in the market] is dealing with”, including Sustainalytics, adding that the ratings do flag funds with an ‘intentional’ dimension but that it was important to treat funds equally and not to give certain funds an “automatic bonus” for something “they say they do”.
He also says that, in future, Morningstar’s ratings could assess a fund’s sustainability based on “two signals” rather than one. That is, “on ESG risk, which is what our sustainability rating would be right now, and then another based on impact”.
In the short term, he says that from next year the ratings will provide more granular information on the strategy of funds, but this still won’t feed into the actual rankings proper.
Hale confirms what RI has previously reported – that Morningstar has plans to release data on ESG voting records, following its acquisition of proxy-tracking firm Fund Votes last month. Hale says this new information will be useful in evaluating the intentionality of funds better.
When asked about the usefulness of sustainability ratings in general, Howard says that they can have “value” providing people understand that they are just “valid opinions” – analogous, in a sense, to something like sell-side research.
But, he adds, that it is “incumbent upon people presenting these ratings to articulate precisely what is being measured, what it is they are trying to capture, and how they are doing that”.
Clarity over what is being measured was also stressed by Latham, who tells RI: “If investors express a desire to invest in sustainable companies, they expect to see sustainable companies in the portfolio and that is going to be based on what products they are selling”.
They wouldn’t expect, he points out, to see companies that are selling products that are “neither here nor there or negative” but who “manage that negative impact to some extent”.
Hale says the ratings have been largely used by intermediaries, such as investment consultants and advisors, as a “basic level of due diligence” that funds are doing what they say they are.
He describes the ratings as a good way to get over the “initial hurdle” in determining a fund’s sustainability profile, rather than giving the whole picture.
Here he is in agreement with Howard who claims: “Sustainability is a broad and complex topic, and if anybody thinks that they have nailed precisely how to analyse it and come up with every nuance of the answer, they’ve misunderstood the question”.