Changes Make Sustainability Rating More Consistent

This month, we are enhancing the Morningstar Sustainability Rating by expanding the number of portfolios that contribute to a fund's Sustainability Score and by using the broader Morningstar Global Category system as the peer group for assigning a fund's Sustainability Rating. We believe these enhancements make the rating a more reliable measure of the extent to which a fund incorporates sustainability factors in its security selection and portfolio construction.

The Morningstar Sustainability Rating is designed to give investors a way to assess the sustainability profile of the holdings in a fund's portfolio relative to a fund's peer group. To make that assessment, we use Sustainalytics' company ESG ratings, which evaluate the material environmental, social, and corporate governance-related risks and opportunities that a company faces. Company ESG scores are rolled up on an asset-weighted basis to get a Portfolio Sustainability Score, and a Sustainability Rating is assigned based on where that score ranks among a fund's peers, using a normal distribution.

While this basic approach is not changing, we have made enhancements to the Sustainability Rating, beginning this month, that we believe will make it a more reliable indicator of a portfolio's ongoing sustainability profile. Because we lacked historical Portfolio Sustainability Scores when we launched the rating in 2016, the rating so far has been based solely on a fund's most-recent portfolio. This limited the ability to make generalizations about a fund based on the Sustainability Rating, because changes in holdings from one portfolio to the next could result in ratings changes. To assess consistency, users had to keep track of a fund's rating themselves, month by month.

Now that we have historical data, we have begun including all of a fund's portfolios over the trailing 12 months when calculating its Portfolio Sustainability Score. Portfolio scores will be time-weighted, meaning the most recent portfolio will weigh more heavily in the score than older ones. Users will still be able to see the score for the most recent portfolio, but instead of that being the only data point and the basis for the rating, it can now be put in context with the 12-month score.

The second enhancement to the rating is the use of Morningstar Global Categories as peer groups. While we currently use the more familiar domicile-based Morningstar Categories, the global categories tend to be much larger, as they include all funds globally that invest in a similar style or asset class. In the global category system, for example, all emerging-markets equity funds are grouped together. In the standard category system, such funds are divided into smaller groups based on the regions where they are available for sale. In some cases, these peer groups were so small that minor changes in portfolio scores sometimes resulted in big swings in the ratings, and we wanted to eliminate that.

We're making two additional, albeit less significant, changes. One is that a portfolio must now have at least two thirds (67%) of its assets covered at the security level by Sustainalytics for that portfolio to receive a sustainability score. The original threshold was 50% of assets covered, but Sustainalytics has expanded its company coverage, allowing us to raise the threshold without significantly reducing the number of funds with sustainability scores. The other minor change is that a global category must have at least 30 funds that receive sustainability scores for any to be rated. The previous threshold was 10, which made it difficult to apply our ratings distribution in such small categories. This change will have minimal impact because most global categories have far more than 30 funds with sustainability scores.

How will this affect a fund's Sustainability Rating? We do expect some ratings changes as a result of the initial changeover. We estimate that about 20% of U.S. large-cap funds will receive different ratings this month based on their 12-month average sustainability scores and relative to their peers in the U.S. equity large-cap global categories as they would have received this month using the previous system. For small- and mid-cap categories, along with world stock, foreign stock, and emerging markets, about one third of funds will receive different ratings than they would have under the previous system. After that, however, we expect the rate of month-to-month changes to be 10% or less in most global categories.

For more information on these changes, please read Interpreting the Morningstar Sustainability Rating Changes," a paper written by my colleague Madison Sargis.

Jon Hale has been researching the fund industry since 1995. He is Morningstar’s director of ESG research for the Americas and a member of Morningstar's investment research department. While Morningstar typically agrees with the views Jon expresses on ESG matters, they represent his own views.