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By Jonathan Bauman - November 2019
Morningstar recently changed the way it evaluates sustainability across all funds. The new environmental, social, and governance (ESG) Risk Rating measures how much a company's economic value may be at risk due to ESG issues. Morningstar started applying the new rating to the September 30 portfolio holdings to calculate globe ratings.
The update happened because data provider Sustainalytics changed the underlying data used for the ratings.1 Prior to the change, Morningstar used to evaluate companies in relation to their competitors. Now, there is one risk scale to rank every company regardless of its sector or industry.
While interest in sustainable investing is clear, the definition of "sustainable" is not. This is partially due to individual preferences—some investors may value one aspect of ESG more than the others.
For example, a person who wants to invest in companies with female board representation may give greater weight to governance (G) factors versus environmental (E) factors. These different values make it difficult to apply a single sustainability standard to all companies. Yet, that is precisely what Morningstar's new rating system is trying to do.
The table below shows the main differences between the old score and the new method:
Sustainalytics and Morningstar's changes impacted the way funds compare to each other in Morningstar's globe ratings. In addition, companies that were the worst players in a favored industry might rank quite high in the new system. That's because the ranking system assumes some industries have higher ESG risk than others—example: energy versus real estate.
Using one risk scale across all industries may make it easy to compare company sustainability to the broader market, but not within similar companies. It would be like comparing all value funds to the S&P 500® Index, instead of a size-appropriate value benchmark. As a result, the measure may devalue companies making significant sustainable progress because they are not in favorable industries.
How will the change affect the way our teams evaluate ESG risk? Download the latest "Notes from the Global Growth Equity Desk" to find out.
1 Sustainalytics is a firm that produces environmental, social and governance (ESG) research on public companies. Morningstar is an investor in Sustainalytics. Morningstar Sustainability Ratings Methodology Changes FAQ , Morningstar, July 2019, version 1.
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A strategy or emphasis on environmental, social and governance factors ("ESG") may limit the investment opportunities available to a portfolio. Therefore, the portfolio may underperform or perform differently than other portfolios that do not have an ESG investment focus. A portfolio's ESG investment focus may also result in the portfolio investing in securities or industry sectors that perform differently or maintain a different risk profile than the market generally or compared to underlying holdings that are not screened for ESG standards.
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