Using our analysis can help infuse sustainability throughout your portfolio.
By Jon Hale, Ph.D., CFA | 12-22-16 | 06:00 AM | Email Article

It has been nine months since we launched the Morningstar Sustainability Rating for funds, a portfolio-based measure of how well the companies in a fund’s portfolio are addressing the environmental, social, and governance, or ESG, issues they face in their businesses. We created the rating to address the rapid growth of interest in sustainable investing, figuring that investors who want to incorporate a consideration of ESG factors into their portfolios could use a tool to help them evaluate, select, and monitor funds and to help them build portfolios.

Jon Hale, Ph.D., CFA, is head of sustainability research for Morningstar.

What does the rating tell us?
At Morningstar, we have always believed that portfolio-based analysis rather than a fund’s stated intentions provides important insights for fund investors. For the first time, investors now have a portfolio-based measure of sustainability. It tells us how well the companies in a portfolio are managing their ESG risks and opportunities relative to those held by other portfolios in the same peer group. Using the rating, investors can now distinguish between funds within many Morningstar Categories based on this measure of sustainability.

Why does this matter?
Many of the world’s largest companies are now explicitly considering sustainability issues as part of their long-term business strategies. In addition, a growing body of research suggests correlations between better company ESG performance and higher-quality management, higher growth, and lower cost of capital. As a result, more investors need some insight into the sustainability performance of the companies in fund portfolios because it makes sense to consider these factors from a material, financial standpoint. Of course, many investors also want to align their portfolios with their preference for companies that treat the environment and their workers well, produce safe and useful products, and govern themselves with transparency and a long-term view.

How should investors use the rating?
As a portfolio-based measure, the rating shouldn’t be used in isolation. It does not address performance or describe an investment process. It does not tell you whether a fund is intentionally trying to be sustainable. But setting it alongside other metrics in a due diligence process can help investors evaluate an existing portfolio, select funds, and monitor them. Perhaps most important, it can help investors who wish to incorporate sustainability build portfolios of funds. Intentional sustainable funds should certainly be a part of such portfolios, but there simply aren’t enough of them to meet the needs of many investors. Less than 2% of funds in the global universe have some sort of explicit sustainable/responsible mandate.

One way to use the ratings is to set them alongside Morningstar Analyst Ratings. Our manager research analysts in the U.S. conduct deep dives on more than a thousand funds every year, assigning Gold, Silver, or Bronze ratings to the highest-quality funds. While you may have specific metrics you look at when evaluating a fund, you could do worse than simply using the Analyst Rating as a proxy for fund quality. And if you wanted to incorporate sustainability into your process, you could set a fund’s Morningstar Sustainability Rating alongside its Analyst Rating, generating a pretty robust list of options. In fact, the Sustainability Ratings of Morningstar Medalist funds in the United States skews positive, with 66 medalists also having the best, 5-globe Sustainability Rating. By contrast, only 32 U.S. medalists have a Sustainability Rating of 1 globe.

Sustainable investors have 26 5-globe Medalist options in U.S. large-cap territory. Five of them are intentional sustainable/responsible funds, which is a good showing considering the still-small number of such funds in the universe. The list includes the standout  Parnassus Core Equity , which is a high-conviction, value-leaning offering, and  TIAA-CREF Social Choice Equity , an indexlike fund that has just about kept pace with the S&P 500 over the long run. The two Amana funds on the list are run by Nick Kaiser and Scott Klimo, who are managers on our Ultimate Stock-Pickers roster (as are Todd Ahlsten and Ben Allen of Parnassus). Broader conventional standouts like the Primecap funds,  Oakmark Select , and  T. Rowe Price Dividend Growth  provide plenty of choice in the large-cap space. If you are especially interested in sustainability, I’d go for an intentional fund in this part of a portfolio. But if you already own one of the conventional funds on the list, its Sustainability Rating means the companies it holds are doing relatively well on ESG issues relative to peers.

Our partner, ESG-research firm Sustainalytics, recently expanded its small-company coverage, allowing us to rate more small- and mid-cap funds. Here, the going gets a little tougher. Fifteen make the list, but more than half are closed to new investors, including  Brown Capital Management Small Company , whose managers received the 2015 Morningstar Domestic-Stock Fund Manager of the Year award. Those that are open include Gold-rated multimanager  Vanguard Selected Value , Silver-rated  Champlain Mid Cap , and quality-growth-oriented Bronze-rated  JPMorgan Small Cap Equity .

Investors can also find foreign-stock, diversified emerging-markets, and world-stock medalist funds that receive 5-globe Sustainability Ratings. Gold-rated  Harbor International Investor  is a quality-growth, large-cap portfolio managed by Northern Cross. Those interested in a world-stock fund (that has both U.S. and non-U.S. exposure) have several choices, including Silver-rated  Artisan Global Value . For emerging markets,  JPMorgan Emerging Markets Equity  is the only 5-globe Medalist fund that’s open to new investors. The fund is a blue-chip, high-quality offering with experienced managers.

The Sustainability Rating allows you to incorporate the concept into your process. It remains difficult to put together portfolios consisting of all intentional sustainable/responsible funds--those that by prospectus say they are seeking to emphasize companies that perform better on ESG factors. Many sustainable investors end up with one or two such funds, with the balance of their holdings in conventional funds. Applying the rating to conventional funds can ensure that sustainability is infused throughout your portfolio.

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Jon Hale, Ph.D., CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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