Setting the Morningstar Sustainability Rating
What is the Morningstar Sustainability Rating?
The Morningstar Sustainability Rating is a reliable and objective way for investors to see how approximately 20,000 mutual funds and exchange-traded funds (ETFs) are tackling environmental, social and corporate governance (ESG) challenges.
Introduced in August 2016, Morningstar’s sustainability ratings are expressed using a five-globe system indicating whether the investment is at the bottom of its industry group’s rating (one globe), below average ( two globes), average (three globes), above average (four globes) or at the top (five globes) of its classification by industrial group. Investors can find Morningstar Sustainability Ratings on the right side of Morningstar.com’s fund rating pages. Morningstar Portfolio Sustainability Ratings are issued monthly.
Understanding the Morningstar Sustainability Rating
Morningstar’s development of this rating system reflects the dramatic increase and importance of sustainable investing. Sustainability ratings are based on two elements: company-level ESG scores developed by Sustainalytics and ESG controversies. Each fund’s ESG score is based on the preparation, disclosure and performance of its underlying companies. Each company in the portfolio is rated on a scale of 0 to 100 relative to other companies in its global peer group. As a result, two companies that have the same score but belong to different peer groups may not have equivalent levels of environmental, social and corporate governance (ESG) performance. A score of 50 means that the company is considered average compared to its peer group; a score of 70 or more means the company is rated at least two standard deviations above the average in its peer group. A score of 30 or less means the company scores at least two standard deviations below its peer group average.
At least half of a portfolio’s assets under management (AUM) must have a corporate ESG score for the portfolio to achieve a sustainability score. The Morningstar Sustainability Rating then takes the portfolio score and subtracts points for controversial ESG issues that the portfolio companies may have. Controversies include incidents that impact the environment and society, such as oil spills, lawsuits for discrimination, or events that affect the business.
According to Morningstar, funds with higher sustainability ratings tend to have higher quality holdings. By top quality, Morningstar refers to funds with sustainability ratings from five worlds that are more likely to have high star ratings for their risk-adjusted returns, are more likely to be favored by Morningstar analysts, are less volatile and have more exposure to healthy companies with economic moats.
However, a fund can have a high rating and a low sustainability rating. For example, Fidelity’s Total Market Index Premium (FSTVX) fund has a Morningstar rating of four out of five stars for its risk-adjusted returns. Morningstar’s premium analyst report calls this fund “an excellent choice for diversified exposure to US equities of all sizes” thanks to its low cost (no load and an expense ratio of 0.05%, well below the group median of 0.90%) and, market cap weighted hedge of the US market. It also carries a gold rating, indicating that analysts expect the fund to outperform over a full market cycle of at least five years. However, it only has a durability rating of two out of five globes (below average) based on an 80% ranking in its category and a durability score of 45.
Morningstar’s sustainability ratings allow investors to orient their portfolios towards a sustainable investment philosophy without having to buy sustainable, responsible and impact funds (SRI, formerly socially responsible investing). SRI funds have several potential shortcomings: they represent a small percentage of the fund universe (around 2%, according to Morningstar estimates) and studies have both proven and disproved their ability to deliver higher returns than their non-SRI counterparts. As a result, many investors are reluctant to invest in SRI funds. In addition, investing in SRI funds may lead to overexposure in some sectors and underexposure in others.
Investors may be more inclined to choose one traditional fund over another based on Morningstar’s relative sustainability ratings. If an investor chooses between two large-cap growth funds with long-term performance and similar investment strategies, and one has a two-globe rating and the other a four-globe rating, the global rating may be the deciding factor.