The Morningstar Sustainability Rating is a consistent and objective way for investors to evaluate mutual funds and exchange-traded funds (ETFs) based on their environmental, social, and corporate governance (ESG) impact.
Implemented in 2016, the Morningstar Sustainability Rating is a rating out of five globes, instead of stars. It indicates whether the fund or investment is rated as the lowest (one globe), below average (two globes), average (three globes), above average (four globes), or highest (five globes) among its comparable industry group. Users can find sustainability ratings on the Morningstar website’s fund quote pages. The ratings are reissued monthly.
Environmental, Social, and Governance (ESG)
Environmental, social, and governance are the three primary factors when measuring sustainability and the societal impact of investments. Investors are becoming more conscious of ESG factors when making investments, and some would argue that companies with a higher consideration for ESG factors tend to outperform companies that do not.
Environmental concerns are focused on areas such as climate change and sustainability. Often, they include consideration of externalities, such as carbon emissions from fossil fuels and diminishing the finite raw materials of the planet.
Social concerns are focused on areas such as diversity, human rights, consumer protection, and animal welfare.
Corporate governance concerns are focused on areas such as management structure, employee relations, executive compensation, and employee compensation.
Morningstar Sustainability Rating Explained
Morningstar implemented the sustainability rating system due to the increased prominence of responsible investing and sustainable investing.
The rating system is based on two components that are developed by Sustainalytics, a subsidiary company of Morningstar. Sustainalytics specializes in rating listed companies based on their ESG performance. The two components evaluated are:
Funds are given an ESG score based on evaluating the underlying companies’ preparedness, disclosure, and performance. Companies within the fund’s portfolio are graded on a scale of 0 to 100 that is relative to other companies within the global industry peer group.
Based on the scoring system, a score of 0 is the worst possible score, a score of 50 is an average score, and the score of 100 is the best possible score.
ESG controversies include research that identifies companies within the funds that have been involved with incidents that negatively impact stakeholders, the environment, or the company’s operations. They can include things such as:
Legal troubles (discrimination or scandal lawsuits)
Environmental damage (oil spills)
Fraudulent behavior (accounting fraud)
Sustainalytics provides a controversy rating from one to five on companies and provides an associated assessment as well.
In order for Morningstar to give a mutual fund or an ETF a sustainability rating, at least half of the fund’s assets under management (AUM) must come with a company ESG score. The Morningstar Sustainability Rating then takes the score of the portfolio and reduces any points that arise from ESG controversies.
Morningstar Sustainability Rating Insights
According to Morningstar, the mutual funds and ETFs that maintain higher sustainability ratings are of a higher-quality and are more sustainable long-term holdings. Therefore, these funds allocate capital to companies that are more favored, less volatile, and maintain a wide economic moat.
With the Morningstar Sustainability Rating, investors can find the ideal investment funds for their individual risk-return profiles while still maintaining a portfolio tilt towards socially responsible investing.
Socially responsible investing is known as sustainable, ethical, or “green” investing. It involves the consideration of various ESG factors within an investment strategy that seeks to both increase financial returns, but also to promote positive environmental/social changes in the world while maintaining transparent and effective corporate governance.
Under the investing philosophy, practitioners emphasize ESG concerns to identify higher-quality companies. Essentially, companies that are profitable, but also consider the best interests of society regarding ESG factors, are more sustainable long term, and therefore, will achieve higher risk-adjusted returns in the long run.
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