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?