What You Need to Know About New ESG Fund Ratings

By Janet Brown 

What makes a fund sustainable?

Many people think that sustainable means environmentally friendly, but sustainable investing actually covers three broad categories: environmental, social and governance (ESG).

Environmental issues are typically the most widely understood, but social and governance policies are just as important. A socially responsible company seeks to treat its workers fairly and create products that help people and are safe to use. A well-governed company balances the needs of its executives and its shareholders. It’s overseen by an independent board of directors and operates in an ethical way without relying on corruption and bribery to get ahead.

ESG policies are often material to a business’ success. There are many examples of companies cutting costs by using renewable energy or conversely getting slapped with fines and lawsuits due to poor environmental results. Studies have repeatedly found that companies with good ESG policies also have performed well.

How to find good ESG funds

How do you find good environmental, social and governance funds?

For many years, the answer was to look for funds that had ‘sustainable’ or ‘socially responsible’ in their names. These funds usually consider a company’s ESG practices as part of their investment selection process. But this can limit your investment choices since only a small fraction of funds self-identify as ‘sustainable’ funds. According to Morningstar, these funds represent just 2 percent of the fund universe.

Today, you can substantially expand your choices by using new ESG -- environmental, social and governance – ratings for mutual funds. A 2016 MSCI study found thousands of funds have “significant exposure to sustainable impact themes," but just 14 percent of these funds are self-professed ESG or sustainable funds. For instance, MSCI found that more than 1,000 U.S. stock funds are “virtually ‘fossil fuel free,' even though very few of these funds – if any – were marketed as such."

Understanding fund ESG ratings

In 2016, MSCI and Morningstar introduced ESG ratings for mutual and exchange traded funds. Both firms rate about 20,000 funds and ETFs on the funds’ underlying holdings.

MSCI has calculated individual company ESG ratings for decades, and now they’re using this data to provide metrics on funds and ETFs. Morningstar is better known for their performance-ratings of funds, and their new sustainability scores are based on ESG data from Sustainalytics. (Morningstar’s globes ratings, as shown on Morningstar.com, indicate how a fund’s sustainability score compares to those of the other funds in its Morningstar category.)

There are limitations to these ratings, however. For instance, they don’t take a fund’s strategy into account. Many funds use their power as shareholders to engage with a firm’s management and file shareholder resolutions. This approach has had notable successes and has really helped companies move forward.

 How to use fund ESG ratings

Fund ESG ratings are certainly a step in the right direction, but you’ll need to decide how to best put them to use in your portfolio. It helps to have a clear rules-based investment approach to help you make the following decisions:

• Will you invest based on ESG ratings alone or will you also consider fund performance?

Funds with terrific ESG ratings aren’t always the best performers (some Europe funds are a recent example), so if you only use ESG scores to select funds, you may not get the returns you need to reach your goals.

• Do you want to support or avoid a particular company or industry?

Fund ESG ratings are based on a fund’s portfolio and not on any one particular stock, so you also may find that some funds with high ESG ratings own companies that you’d don’t want to support, or they may not focus on the issues that are most important to you. Fidelity Growth & Income Portfolio (FGRIX), for instance, has a good ESG rating, but it owned Monsanto in its portfolio last month, a company that some investors seek to avoid.

• What will you do if a fund’s ESG rating changes?

Fund ESG ratings also will change over time, so you’ll need to check on your funds to make sure they’re still up to your standards.

Image credit: Pixabay

Janet Brown is the President and CEO of FundX Investment Group. She manages fund portfolios for high-net worth clients and foundations. She also manages a sustainable mutual fund. Janet is a board member of several non-profits and foundations and a longtime advocate for sustainable, responsible impact investing (SRI).