The Morningstar Sustainability Rating is a reliable and objective way for investors to see how approximately 20,000 mutual funds and exchange-traded funds (ETFs) are meeting environmental, social, and corporate governance (ESG) challenges.
Introduced in August 2016, Morningstar’s Sustainability Ratings is expressed using a five-globe system indicating whether the investment is at the bottom end for its industry group (one globe), below average (two globes), average (three globes), above average (four globes) or at the high end (five globes). Investors can find Morningstar’s sustainability ratings on the right-hand side of Morningstar.com’s fund quote pages. The Morningstar Portfolio Sustainability Ratings are issued monthly.
Morningstar’s development of this rating system reflects the dramatic increase and importance of sustainable investing. The sustainability ratings are based on two things: company-level ESG scores developed by Sustainalytics and ESG controversies. Each fund’s ESG score is based on its underlying companies’ preparedness, disclosure and performance. Each company in the portfolio is graded on a scale of 0 to 100 relative to other firms in its global industry peer group. As a result, two companies having the same score but belonging to different peer groups may not have equivalent levels of ESG performance. A score of 50 means the company is average relative to its peer group; a score of 70 or higher means it scores at least two standard deviations above average in its peer group; and a score of 30 or lower means it scores at least two standard deviations below average in its peer group.
At least half of a portfolio’s assets under management (AUM) must have a company ESG score for the portfolio to get a sustainability score. The Morningstar Sustainability Rating then takes the portfolio’s score and subtracts points for controversial ESG-related issues that companies in the portfolio are involved in. Controversies include incidents that impact the environment and society, such as oil spills or discrimination lawsuits, plus that incident’s effect on the company.
According to Morningstar, funds with higher sustainability ratings tend to have higher-quality holdings. By higher quality, Morningstar means that funds with five-globe sustainability ratings are more likely to have high star ratings for their risk-adjusted returns, are more likely to be favored by Morningstar analysts, are less volatile, and have more exposure to financially healthy companies with economic moats.
That being said, a fund may have a high star rating and a low sustainability rating. For example, take Fidelity’s Total Market Index Premium fund (FSTVX), which has a 4-star Morningstar rating out of 5 for its risk-adjusted returns. Morningstar’s premium analyst report calls this fund “a great choice for diversified exposure to U.S. stocks of all sizes” thanks to its low cost (no load and an expense ratio of 0.05%, well below the group median of 0.90%) and its “broad, market-cap-weighted coverage of the U.S. market.” It also carries a gold rating, indicating that analysts expect the fund to outperform over a full market cycle of at least five years. However, it only has a sustainability rating of 2 globes out of 5 (below average) based on an 80 percent ranking in its category and a sustainability score of 45.
Morningstar’s Sustainability Ratings make it possible for investors to tilt their portfolios towards a sustainable investment philosophy without having to purchase sustainable, responsible, and impact (SRI, formerly socially responsible investing) funds. SRI funds have several potential shortcomings: they represent a small percentage of the fund universe (about 2%, according to Morningstar estimates) and studies have both proven and disproven their ability to offer higher returns than their non-SRI counterparts. As a result, many investors are hesitant to invest in SRI funds. In addition, investing in SRI funds can mean getting overexposed to some sectors and underexposed to others.
However, investors may be more inclined to choose one traditional fund over another based on the funds’ relative Morningstar Sustainability Ratings. If an investor is choosing between two large-cap growth funds with similar long-term performance and investment strategies and one has a two-globe rating and the other a four-globe rating, the globe rating may be the tiebreaker.