Jon Hale is the head of sustainability research at Morningstar Inc. Financial Advisor contributor Paul Ellis recently interviewed him to discuss Morningstar’s Sustainability Rating system and how advisors are using it.

Ellis: Jon, Morningstar launched the ESG rating system in March of 2016. How is it being used most effectively by financial advisors and RIA teams on behalf of their investor clients?

Hale: The Sustainability Rating is a measure of how well the holdings in a portfolio are performing on a range of ESG measures relative to peers. Advisors, so far, are  using the ratings in at least three different ways.

First, advisors gearing up to incorporate ESG factors in portfolio analysis are using it to evaluate existing, non-ESG-focused portfolios. They want to know how the funds they are already using fare on sustainability metrics. These advisors tell us that they are generally responding to client demand for sustainable investing choices as a way of enhancing the client relationship.  

This creates the opportunity for them to begin the sustainable investing conversation by looking at how well the funds already in their clients’ portfolios are doing on sustainability, and identifying funds that may be first in line to replace. The second way is that advisors are starting to incorporate the ratings into their screening process, alongside the other metrics they routinely use in portfolio selection. In so doing, they can build client portfolios that incorporate sustainability without having to rely solely on traditional ESG-focused options.

On a related note, the third way is to use the ratings to identify additional fund choices when there are not competitive ESG funds available for a particular asset class or style of investing that the advisor wants to use in a client’s portfolio. I recommend that advisors first consider intentional ESG funds, but default to conventional portfolios that do well on our Sustainability Rating when ESG-focused fund options are not competitive or, in some asset classes, are non-existent.

A good example of this is emerging markets equity where there are few intentional ESG funds available. Rather than ignore emerging markets altogether or rely on conventional funds without reference to sustainability, advisors can now use our ratings to find emerging markets funds that hold better ESG-performing companies.

Ellis: You post articles on sustainable investing regularly on the Morningstar website. Did you want to say anything more about Morningstar’s internal ESG research process?

Hale: We’re still exploring the data, but have found a couple things about the typical profile of funds that rate high on sustainability. They also tend to be lower in volatility, to have somewhat lower portfolio turnover and are of higher quality relative to funds that rate low on sustainability. This early data suggests that funds with high sustainability ratings may be better performers over the long term.

Ellis: I consult with RIAs that are using the ESG rating system in the second way you mentioned above. Was there intention behind the construction of the rating system that it would be used in this way?

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.

Ellis: Another area of growth is the green bond market. Does Morningstar have plans to incorporate ratings of fixed-income funds in this process?

Hale: We want to address fixed income but we’re still in the exploratory stages of looking at green bonds and municipal bonds. An assessment of current municipal bond portfolios on sustainability issues could spur a lot of investor interest. 

Ellis: Are there other asset classes that will be added to the Sustainability Ratings system?

Hale: Sustainalytics has expanded its ability to cover smaller companies, so we’ve expanded our fund-level ratings to small-cap equity funds. Also, our Sustainability Ratings are now available for separately managed accounts, which I think is an invaluable tool for advisors using those vehicles.

Ellis: Any other ideas on how advisors can use the Sustainability Ratings system, Jon?

Hale: For advisors who use intentional ESG funds, the rating is a proof of concept for whether the fund is doing what it claims to be doing. Our rating doesn’t have to be the final word on sustainability, but advisors can use it as a basis for dialogue about ESG with fund managers. I think such conversations are good for transparency and for clarity surrounding sustainable investing.     

Paul Ellis founded Paul Ellis Consulting to work with financial advisors who want to integrate sustainable and impact investment strategies for their clients.