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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.
CPM Jonathan Bauman breaks down the recent Morningstar Sustainability Ratings changes by sector, company and fund.
The American Century Sustainable Equity Strategies apply our unique blend of financial analysis and environmental, social, and governance (ESG) screening criteria to provide a comprehensive view of a security.
The American Century® Small Cap Growth Fund pursues high growth through investments in smaller companies exhibiting both sustainable accelerating earnings growth and positive price momentum.
The American Century® Equity Income Fund seeks to deliver income, build capital and manage downside risk over time.
When portfolio managers incorporate Environmental, Social and Governance (ESG) factors into an investment strategy, they consider those issues in conjunction with traditional financial analysis. When selecting investments, portfolio managers incorporate ESG factors into the portfolio's existing asset class, time horizon, and objectives. Therefore, ESG factors may limit the investment opportunities available, and the portfolio may perform differently than those that do not incorporate ESG factors. Portfolio managers have ultimate discretion in how ESG issues may impact a portfolio's holdings, and depending on their analysis, investment decisions may not be affected by ESG factors.
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