Hale: Yes, absolutely. That was one of the key ways we thought the ratings would be effective. When you’re trying to put together a portfolio that incorporates sustainability, there aren’t all that many dedicated funds available.
In my previous role with Morningstar Investment Management, I put together multi-manager ESG portfolios for Pax World Funds. We found that we didn’t have a wide range of choices when limiting ourselves to the ESG-focused funds.
Maybe that’s a temporary problem as ESG becomes more widely adopted and fund companies provide more products. In the meantime, what the ratings do is expand the universe of funds that may be suitable for a sustainable investor.
If I want to integrate sustainable funds into my portfolio and my advisor finds a few intentional ESG funds and then includes conventional funds that score well on our ESG rating system, I will likely be happy with that mix. It’s a good solution for these issues and a way to supplement an otherwise intentional ESG portfolio.
Ellis: How will the rapid growth of ESG indexing find its way into the ratings process and will it be beneficial to the industry?
Hale: The important thing about our rating is that it can be applied to any investment product, including indexes. It’s inevitable that we’re going to have more ESG-rated index funds because of the broader movement in the industry toward passive products. The performance of intentional, actively managed ESG funds will certainly be challenged by passive ESG indexes, as is the case for conventional, actively managed funds and their competing indexes.
Ellis: Are there metrics that you can share with our advisor readers that are being used as part of the ESG rating system as you develop it across product categories?
Hale: The Sustainability Ratings are currently based on the ESG performance of underlying holdings as measured by Sustainalytics. We’re aware that there are other views out there on sustainability, so we’re looking at ways to evaluate a fund’s carbon footprint and sustainability impact, for example.
We’re also looking at providing more detailed information about intentional ESG funds in our database. For example, how does a fund incorporate ESG in the portfolio construction process, what traditional screens does it use, if any, and what active ownership role does it take? I think that active ownership is important to sustainable investing and a key selling point for intentional ESG funds. Investors consider it to be a value-add they get for having a fund with a comprehensive sustainability focus.
There was a time when intentional funds didn’t emphasize active ownership much in their marketing materials. Now that there’s more investor interest in having an impact, these funds are starting to make that connection, and I think it’s a compelling point for them to make.