The Failure of Fund Sustainability Ratings
Morningstar adding mutual fund sustainability ratings were a welcome addition to the broad landscape of sustainable and impact investing when introduced in early 2016.
By adding an assessment of 1–5 Globes to their fund pages (shortly to be featured on Yahoo Finance as well), the general public gains a first, simple perspective on ESG and investing. But other than their ability to attract attention to ESG data on companies, Morningstar’s Globe system and similar ratings aren’t particularly useful for investors.
By taking a ‘holdings-based approach’ — a weighted average of portfolio companies’ ESG scores — fund sustainability ratings such as those calculated by Morningstar don’t tell what you need to know if you want to have impact with your investments. No credit goes to investors on their efforts on shareholder engagement and public advocacy or on their sophistication, culture and investment strategy.
Do you know how many Morningstar Globe points Boston Common Asset Management’s funds get for leading a coalition of investors to persuade banks to limit coal financing? How many points Trillium’s funds get for leading an investor statement opposing North Carolina’s discriminatory bathroom bill, part of an ultimately successful effort? And what about all the fund managers that have pushed companies to stop funding organizations supporting climate denial, address the gender pay gap, phase out antibiotic use, and much more? No points. Exactly 0.
Morningstar, MSCI, Barron’s, and even the new Corporate Knights sustainability fund ratings ignore or significantly undervalue shareholder engagement and public advocacy. For example, the 5-Globe rated Fidelity US Sustainability Index Fund, which has been doing next to nothing to create environmental and social benefit through engagement and advocacy, is judged the same as the Domini Impact Equity Fund (also 5 Globes). Domini has consistently influenced corporate behavior, from securing protections for migrant workers to persuading companies to disclose their political spending. This growing wave of investor engagement, reinforced by BlackRock CEO Larry Fink’s latest letter, also matters.
Holdings-based approaches also ignore intentional ESG strategy. Rather than reward thoughtfulness, holdings-based ratings analyze only where corporate ESG data and portfolio holdings overlap. This should be worrying because there is no ESG consensus — different data provider’s sustainability ratings often diverge on what constitutes good sustainability performance.
The correlation between the two major rating systems, Sustainalytics and MSCI, is just 0.32. Companies themselves are therefore getting mixed signals about what ESG factors are important. To be clear, there are benefits to this diversity of thought. Such conflicts can encourage critical thinking on all sides, helping the field as a whole develop. But this is further evidence that fund ratings such as the Morningstar Globes are insufficient.
Furthermore, ESG data won’t reflect the most important corporate outcomes investors need to help enable to happen. Largely past performance based ESG metrics won’t help investors figure out: 1) who will create the driverless, low carbon cars and trucks that the market will most take to, 2) what the future of the electric utility in the US will be, and 3) nearly anything at all about countries like China, where ESG data is insufficient at best.
Moreover, how a manager invests is just as important as where it invests. Fund manager intentions in aggregate affect the decisions of company management, for better or for worse. In a holdings-based approach, the funds that demanded that electric utility NRG sell off its renewables assets would receive the same points as funds that supported NRG’s sustainability strategy. Impact ratings should not reward investors that slash sustainability practices in favor of short-term profit.
All this is disappointing because there is so much potential for fund ratings to be helpful. Imagine if ratings guided more investors towards funds that are investing intentionally and improving corporate sustainability through engagement with companies, policymakers and the public. Consider that after years of intransigence, new pressure from large asset managers pushed Exxon to agree last month to disclose climate risks. More assets behind these efforts creates more influence.
What is needed most of all is a movement, and a community, of transparent commitment to the principles of real impact, providing necessary checks and balances on corporate activity. In the current political climate, such a movement is urgent.
We co-founded Real Impact Tracker because friends and family were falling into the trap of conflating fund sustainability ratings with impact. Real Impact Tracker takes a more holistic approach to fund ratings; our scoring methodology focuses on activities that the academic literature shows to be truly impactful — namely ESG investment strategy & performance, as well as shareholder engagement, public awareness raising and policy advocacy. We just launched our Real Impact Certified Community of fund managers to highlight those committed to real impact that can actually change the world.
(this piece was written with input from my Real Impact Tracker colleagues Pei Hua Chen, Gabe Rissman and Patrick Reed)