A number of financial information providers, including Morningstar, Sustainalytics, MSCI, 3D Investing and As You Sow, have recently launched third-party ratings with the objective of providing investors with a guide to the overall ‘sustainability’ of investment funds.
These ratings may be helpful to investors when considering environmental, social and corporate governance (ESG) risks and opportunities.
However, there are some important differences in the underlying methodologies of these ratings providers in the emphasis they place on aspects of the investment process.
Some, such as 3D and As You Sow, are focused on whether the fund delivers a positive environmental or social outcome by directing investment towards solution providers and avoiding significant polluters. Others, such as Morningstar, are more focused on assessing how companies operate on a day-to-day basis and include a reference to corporate governance practices, with less reference to what they do as a business activity.
By focusing only on operational aspects of companies’ activities, some of the ratings may be misleading to investors looking for long-term sustainable investments.
Other unintended consequences relate to company size and geography. For example, larger companies tend to have more developed ESG disclosures and European companies have significantly more developed reporting than US or Asian companies.
The company size and geographic allocations of a fund may, therefore, significantly skew the fund rating results. Hence funds investing in large European oil and gas companies facing future carbon regulations may score better on ESG quality than funds investing in smaller US water-treatment or renewable-energy companies, providing long-term solutions in the transition to a sustainable economy.
Investors need further clarification from the raters in order to understand how to compare funds meaningfully.
Integration of a few considerations into the ratings methodologies would provide more consistent and meaningful ratings:
1. Intentionality
Incorporate an explicit reference to the ‘intention’ of a fund. For example, to invest in environmental solution providers and integrating ESG analysis (sustainable investing) or focusing only on companies with better processes (higher ESG scores), across all sectors (best-in-class). Funds just investing in companies with high ESG scores have a different focus than funds investing in companies providing positive environmental benefits.
2. Peer groups
Establish the most relevant fund peer groups. Once the ‘intention’ of funds has been established, more appropriate peer groups can be established, allowing more meaningful and accurate comparisons across funds.
3. Company size
Include broader ESG ratings coverage of smaller and mid-sized companies.
Higher ESG scores are highly correlated with market capitalisation. Larger companies can easily afford to submit the reams of data often requested by ESG rating providers whereas smaller companies can struggle to provide all the data required and often receive lower ESG ratings as a result. ESG rating firms also often lack coverage of smaller companies, further skewing results.
4. Geography
Take into account or normalise for geographic focus of funds. Funds that are focused on, or overweight, European companies are more likely to score better, given that ESG disclosures are much more developed in Europe than in the US or Asia.
