A Deeper Look Into ESG Fund Strategies

Morningstar’s new ESG Commitment Level allows investors to better understand which strategies rise above the crowd in their commitment to ESG.

Matias Möttölä, CFA 09 December, 2020 | 16:55
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Since 2016, Morningstar has offered investors the Morningstar Sustainability Rating, or "globe" rating, which is a holdings-based measure of a portfolio’s environmental, social, and governance risk relative to peers. While a useful metric, it cannot capture the full breadth of factors that differentiate the ESG commitment employed by a fund manager in a strategy.

To allow investors a fuller view of funds’ ESG investing strengths, Morningstar has introduced a new qualitative measure, the Morningstar ESG Commitment Level for strategies. It delivers an analyst’s qualitative appraisal of the extent to which strategies incorporate ESG factors. Our initial white paper, which was launched on Nov. 17, 2020, includes 147 funds, representing 107 strategies. 

Going forward, we will produce the Morningstar ESG Commitment Level for all strategies (and asset managers) for which we produce Morningstar Analyst Ratings (funds will be assigned an ESG Commitment Level whether or not they profess to be an ESG offering).

Based on our analysts’ rigorous assessment, we assign each strategy into one of four levels: Leader, Advanced, Basic, and Low.

Leader strategies are truly and fully committed to ESG investing. Leaders integrate ESG factors fully into their security analysis and portfolio

construction and deliver desirable ESG outcomes at the portfolio level, such as lower CO2 emissions than the benchmark, advancing of UN Sustainable Development Goals, or similar. To make this happen, the investment teams in these funds are armed with best-in-class data resources, and analysis is carried out by a well-sized team with a strong specialization in ESG. Finally, Leader strategies use proxy voting and engagement purposefully to push companies toward sustainable practices and would typically have best-in-class reporting on their active ownership activities.

The Leader group is highly selective by nature. Following in their footsteps are funds achieving an Advanced ESG Commitment Level. At this level, too, ESG is a key part of the strategy even if they fall short of Leaders in one or more areas. At the security research level, these funds must be doing more than just using ESG data as an alternative data source. We expect ESG to at least affect portfolio weights and risk management decisions and even drive portfolio-level targets to meet certain sustainable metrics. To deliver such outcomes, the team has to exhibit strong ESG credentials.

Funds at the Basic level can demonstrate that ESG is incorporated in the investment process to a certain degree and that they have the resources and expertise to implement this. We expect to assign this level to many traditional funds with a well-executed ESG integration process and funds that apply simple exclusionary screens.

Finally, funds at the Low level are either doing nothing or little on the ESG front. It may also be that, despite claims of ESG incorporation within securities research, the team doesn’t really have credible ESG resources, or while resources are made available, ESG considerations don’t really sway the portfolio manager’s investment decisions. One group of funds populating the Low level are index funds that track a traditional benchmark without any ESG screening, even if the asset manager is engaging and voting to improve the holdings’ ESG credentials.

Multilevel Qualitative Analysis

To arrive at one of these four levels for each strategy, Morningstar analysts assess three key pillars--Resources, Process, and Asset Manager--as components of the overall evaluation. Analysts consider a range of different

elements in their assessment of each, and they score the pillars on a four- point scale.

Resources Pillar

When evaluating Resources, analysts assess the ESG expertise of the people who have input into the strategy, as their contribution to the approach and execution of the process ultimately impact the outcomes at the portfolio level. For example, does the portfolio manager have experience and expertise in ESG analysis and investing? The wider resources available to the manager and how those resources are structured are also considered here, such as whether specialist ESG analysts are embedded within the investment team or if the ESG team is distinct from the traditional financial analyst team. If it is the latter, our assessment seeks to understand the nature of the relationship between the teams, the lines of communication, and how they interact. Where an ESG team and a traditional investment team have differing views on the merits of a security, we seek to identify where investment decision-making authority lies. Regardless of the setup: Is the group of ESG specialists of appropriate size, does it have the ability and experience to service the strategy effectively, and is the team a settled unit?

The availability of appropriate data is also a significant consideration within the Resources Pillar. While asset managers are accustomed to evaluating huge amounts of traditional financial data when making investment decisions, for many, incorporating ESG data is not as established into the process. We therefore consider what ESG data is available to managers and analysts as an input into the decision-making process and to what extent they make use of this data. Some managers may have proprietary internal ESG ratings available to them, which could be a differentiating factor compared with those reliant on external providers.

Process Pillar

When evaluating Process, Morningstar analysts are seeking to identify the extent to which ESG considerations are truly integrated into the overall approach. This spans all stages of the investment process, from the definition of the investable universe (negative and positive screening), to qualitative investment analysis, security selection, portfolio construction, and risk management. As outlined earlier, simple negative screening alone is not

enough to score highly here. Other factors at play include the significance of ESG criteria versus traditional financial characteristics in the fundamental analysis of securities, whether certain ESG metrics/targets are managed at the overall portfolio level, and if specific ESG criteria or scores directly impact position sizing in a systematic fashion. Further, consideration is given to how a red-flag ESG issue at a portfolio company is handled and whether the portfolio manager is required to take any action as a result. Morningstar analysts will cross-check their findings with the publicly disclosed portfolio to see whether it matches their expectations of the stated approach. Metrics such as the Morningstar Sustainability Rating and company-level research from Sustainalytics may be of relevance here.

Active ownership, via company engagement and proxy voting, is another central consideration of the effectiveness of a strategy’s approach to ESG. In many cases, such functions are carried out by a central resource at an asset manager, but we seek to understand the degree to which portfolio managers are involved when their portfolios hold securities of the company in question and whether those responsible for active ownership activities work closely with investment teams to share insights.

Asset Manager Pillar

The assessment of the asset manager is provided by the Morningstar ESG Commitment Level for asset managers, a separate evaluation of ESG credentials at a groupwide level, and this then feeds into the strategy-level ESG Commitment Level as one of the three pillars. The Morningstar ESG Commitment Level for asset managers is based on our analysts’ evaluation of a firm’s ESG Philosophy & Process, Resources, and Active Ownership. For a full discussion on how Morningstar assesses asset managers in this context, see "For ESG, the House Has an Impact."

In order to assess the pillars described above, Morningstar analysts gather data and analyze portfolios using a variety of metrics, as well as conducting interviews with portfolio managers, ESG specialists, and other appropriate personnel at asset management groups.

For active strategies, the pillar scores are combined into an overall ESG Commitment Level according to the following weightings:

Resources: 35%

Process: 45%

Asset Manager: 20%

The pillar weightings for passive strategies are different, reflecting that the ESG characteristics for passive strategies are largely determined by the properties of the indexes they track rather than by internal ESG experts, data, and systems. The integration of ESG into the index’s construction is reflected in Process, which is weighted at 80% for passives.

Process: 80%

Asset Manager: 20%


Read the Full ESG Commitment Level Methodology

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Matias Möttölä, CFA

Matias Möttölä, CFA  Matias Möttölä, CFA, on Morningstar.fi-sivuston päätoimittaja ja rahastoanalyytikko

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