Do Morningstar Medalists Have Higher Sustainability Ratings?

Does the Morningstar Sustainability Rating align with the Morningstar Analyst Rating? One might intuitively expect some correlation between the two. The Sustainability Rating is a portfolio's Sustainability score relative to its Morningstar Category peers. The score measures how well a fund's holdings are managing environmental, social, and governance, or ESG, risks and opportunities relative to their industry groups. Funds with higher ratings are arguably managing company-specific risk better, which might lead to stronger risk-adjusted performance over the long term.

A look at the initial release of the data suggests that Morningstar Medalists in the United States tend to have modestly higher Sustainability Ratings. As of March 14, 2016, 341 medalists had Sustainability Ratings. (In order to receive a rating, at least 50% of a portfolio's assets under management must have an underlying company ESG score, and bond, small-cap, and allocation funds often do not meet that hurdle.) Those Sustainability Ratings skewed slightly positive, compared with the normal distribution used to assign the ratings overall: 36.4% were High or Above Average, while 32.1% were Low or Below Average--the expected distribution is 32.5% for both groups.

It's worth noting that broad market index funds are more likely to have Average or lower Sustainability Ratings. Because they hold so many positions, their portfolios tend to score Average on the ESG component of the rating, and because they don't sell firms in response to a controversial incident, controversy deductions can bump the overall rating down to Below Average. When index funds that earn medals are excluded, the U.S. medalists' Sustainability Ratings looked a bit better relative to the overall group. Because a disproportionate number of index funds are rated Gold, the effect is particularly pronounced among Gold-rated funds. Among Gold-rated actively managed funds, only 24% have Low or Below Average Sustainability Ratings, while 36% are in the High or Above Average camp.

It would be premature to conclude that high Sustainability Ratings are an indicator of future outperformance. After all, low-cost index funds are still tough to beat. More important, we don't have a history with this data point yet. The Sustainability Rating is a snapshot of a portfolio at a particular point in time, and we don't yet know much about the stability of this rating.

As we accumulate data, we may find that even a persistent pattern of low Sustainability Ratings does not preclude strong long-term investment performance.

As Morningstar builds a historical database of Sustainability Ratings and the underlying numbers, analysts will continue to explore the relationship between this data and performance, risk, and other Morningstar ratings.