For ESG, the House Has an Impact

Around the world, environmental, social, and governance considerations in investing are gathering steam. More and more, investors are considering how ESG may play a part in their portfolios. Asset managers are attuned to this growing interest and demand, and many are responding. What they have done, and how they are progressing, can have a substantive impact on what an asset manager can deliver to investors and on how it can advance ESG initiatives more broadly on behalf of its clients.

On Nov. 17, 2020, Morningstar unveiled its Morningstar ESG Commitment Level. In that initial rollout, our manager-research analysts produced these assessments on 107 individual strategies and 40 asset managers. Morningstar’s analysts will eventually produce these ESG Commitment Levels for other funds and asset managers included in our coverage. In addition to weighing a strategy’s ESG process and resources, these levels will include a distinct assessment of the investment houses most closely tied to a fund’s ESG imprint--in the Morningstar ESG Commitment Level for asset managers. This level commands a 20% weighting in the overall vehicle assessment.

Parental Guidance Investors who want to understand how and the extent to which ESG factors are incorporated into the strategies they own or are considering to buy should also consider what the asset management firm brings to bear. As is the case with functions like compliance, risk management, and (often) investment research, ESG resources can be leveraged across an organization, and so how a firm develops and shares these resources can be critical. When it comes to proxy voting, bringing the full weight of an organization to an issue on a ballot can be more impactful. And a firm can support an ESG-friendly tone from the top by formally monitoring portfolio managers' incorporation of ESG and incentivizing desired behaviors and outcomes, among other tools.

In evaluating a firm’s ESG commitment, Morningstar’s analysts will dig into these issues and more, bucketed into three main components at the firm level: Philosophy and Process (40% of the ESG Commitment Level for asset managers), Resources (30%), and Active Ownership (30%). A firm’s overall score will then help analysts place asset managers in one of four tiers: Leader, Advanced, Basic, and Low.

For Leader firms, ESG is often core to a firm’s identity. They have long histories committed to ESG investing, and ESG considerations are ingrained and pervasive across the firm--in their investment processes, strategies, and voting records and in their own operations. These firms are transparent and educative about their ESG efforts and thinking.

Advanced firms are deliberate in integrating ESG into their investment processes using robust resources and formal monitoring. They articulate their approaches toward ESG but may demonstrate a more limited application across the firm than Leader firms do. Still, Advanced firms are among the industry’s better ESG proponents.

Firms that earn a Basic ESG Commitment Level incorporate ESG at a lesser level than Leader and Advanced firms or they may be earlier in their ESG development. These firms tend to be lacking in one or more aspects central to a stronger ESG effort.

A Low ESG Commitment Level can indicate different things: A firm simply may not be determined in its ESG incorporation, and thus not use ESG criteria at all or may consider ESG in a limited or more-variable way; or, it may be doing a poor job incorporating ESG into its investment programs or in otherwise advancing ESG initiatives.

Parental Pillars In determining an asset manager's ESG Commitment Level, Morningstar analysts consider three pillars: Philosophy & Process, Resources, and Active Ownership.

Philosophy & Process When Morningstar analysts consider a firm's Philosophy & Process, they are assessing how important ESG is to the character of the firm and whether the firm has convincingly demonstrated that definition and distinction. Pieces of this evaluation include straightforward questions--is the firm a signatory to the UN-supported Principles on Responsible Investment, for example, and has the asset manager established any firmwide exclusions from portfolios? But analysts must also assess if the asset manager's purport is genuine and if it demonstrates accountability for what it professes. Incorporating ESG into investment processes across asset classes and investment vehicles demonstrates a collective agreement among an asset manager's professional investors that ESG should be considered and that the team is united in an ESG philosophy. A formal monitoring of how portfolio managers incorporate ESG in their processes and being transparent with clients about ESG metrics for each strategy helps keep a firm and its investment teams accountable to a clearly articulated philosophy.

Resources ESG investing is complex. It often requires specialized knowledge or skill sets; adding to the complexity is the new and changing nature of the field. For example, investor preferences can be varied, definitions nebulous, and regulatory and political considerations fast-moving. Resources are thus critical. In their evaluation of Resources, Morningstar's analysts assess whether a firm's people, data, and systems are appropriate. Firms have choices in how they organize their ESG people--will they build a separate team of specialists, or do they develop specialization within the investment team? What matters more is that the ESG expertise in the house is well-trained and/or experienced in the complexities of ESG investing. Are the firm's ESG people resources building tenure with the firm, or are they jumping to another shop--something that can be a challenge as multiple firms begin and continue to invest in this area. Third-party data sets provide much-needed information and context, but developing proprietary ESG data evaluations furthers an investment organization's understanding of ESG and can distinguish its analyses from the competition. Translating and sharing ESG analyses with investment analysts and portfolio managers is a critical piece in having an impact on portfolios and clients, and so systems built to facilitate shared understanding are also important resources.

Active Ownership Especially when it comes to furthering ESG initiatives, the asset manager has a powerful tool: its right to vote as an equity shareholder. Most equity shareholders profess that they have long been concerned with governance issues and have voted accordingly; this is likely true for most, at least on some of the more unfriendly corporate-governance practices. Environmental and social concerns and voting records that support them, though, are newer or virtually nonexistent for many asset managers. Morningstar analysts thus look for clear environmental and social proxy-voting guidelines and examine asset managers' track records on voting in favor of ESG resolutions. Engagement is another form of active ownership, one that both equity shareholders and bondholders can perform. Engagement runs along a spectrum--from one-time, one-way communication (a letter to the CEO, for example) to multiple interactions with multiple people and clear expectations expressed. Firms on the latter end of the spectrum score higher on engagement. Another piece here evaluates how transparent a firm is on both its proxy voting and its engagements--the more, the better.

Conclusion Interest in ESG investing is growing, and that investor preference has driven asset managers to respond in a variety of ways. Some investment firms are just getting started on considering ESG, and it remains to be seen if their efforts will be permanent or convincing. Others have some pieces down, like a well-intentioned approach and dedicated resources, but are shabby in others, like proxy-voting records. Still others are happy to focus on valuations and investment merit only, without ESG (or without ES). And some are all-in on ESG. It's a lot to sift through, but the Morningstar ESG Commitment Level for asset managers sheds some light.