Until recently it has not been an easy task for a sustainability-focused investor to ascertain whether the funds he or she owns reflect best sustainability practices.
This is because investors have not had a standardised way to assess how companies held by a fund are managing the environmental, social, and governance (ESG) risks and opportunities that they face.
In most cases, sustainable investors have typically sought funds with an intentional sustainability mandate, therefore relying on fund managers’ professed approaches to sustainability.
This poses several issues. In the first instance, intentional ESG mandates can vary widely in their parameters across funds and may also give the portfolio manager of any given fund considerable latitude for interpretation.
To give just one example, some ESG managers are willing to invest more heavily in companies that don’t yet exhibit desirable ESG practices, with a view to changing the firms for the better through close engagement with boards and management teams of the businesses.
It is thus not necessarily always clear whether the outcome is a sustainable fund or one that is on the journey to becoming sustainable.
Investors are left with a severely restricted opportunity setMoreover, while some fund groups have invested heavily in forming specialist governance committees that take part in active corporate engagement and conduct valuable research on the way companies handle ESG issues and controversies, the influence these committees have on the trading decisions of fund managers is often limited.
This accentuates the subjective nature of engagement and the heterogeneous ESG approaches.
It’s therefore quite difficult for investors to understand objectively the type of exposure they are getting from a given ESG mandate, and how it might compare with other choices in the market.
Further, in narrowing their choices to intentional ESG funds, investors are left with a severely restricted opportunity set because funds with dedicated ESG mandates comprise a small portion of the overall fund universe.
Given the many ways that such mandates are open to interpretation, it’s not clear that such an extreme sacrifice of investment choice is warranted.
Morningstar’s sustainability rating gives investors a fresh perspective on how well the underlying companies in a fund are doing on a sustainability basis relative to their peers, and also helps them compare funds within categories and relative to benchmarks.
Judging funds using this method also helps expand the universe of funds that could be acceptable to a sustainable investor beyond those that have an explicit ESG mandate.
Some funds can score well on sustainability across different sectors, regions and asset classes, even in the absence of a specific ESG mandate.
Expanding universes in this way can help investors fill out their portfolio allocations and achieve their investment goals.
Muna Abu-Habsa is senior manager research analyst at Morningstar
