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Save the trees while you invest

Glenn Freeman  |  02 Aug 2016Text size  Decrease  Increase  |  

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Investors concerned about environmental, social and other issues around sustainability now have a sophisticated new process open to them for ranking Australian and global companies.

Morningstar Sustainability Ratings were rolled out across the global Morningstar group from July 2016, using a methodology created in partnership with ESG ratings specialist Sustainalytics.

This uses a data-driven process to rank investment funds according to their performance against environmental, social and governance (ESG) criteria.

Socially responsible investing has traditionally involved screening out specific companies or sectors from investment portfolios. For instance, by avoiding investing in companies involved in gaming, tobacco, fossil fuels or carbon-intensive industries.

But over the last few years, much of the investment industry has moved on from divestment as a strategy.

"There are all these ESG-related factors that you can look at, and that is what we're trying to work through: which companies are doing a better job at managing this," says Anthony Serhan, Morningstar's managing director of research strategy, Asia Pacific.

"When you're assessing multiple organisations, this tends to be more of a best-in-class approach. This is the more recent trend over the last five years, and this is where we believe things are heading [in sustainable investing]."

Morningstar's new approach is a data-driven methodology for "positive screening"; so the end investor can opt to buy shares in companies that meet specific best-in-class parameters.

Often, the first step for people wanting to invest sustainably is expressing a view on companies that they don't want to be a part of.

How it works

As an investor, one of the most challenging aspects of maintaining a focus on sustainable companies is knowing whether your chosen stocks really are compliant with the ESG principles they claim to espouse.

This is where Morningstar's Sustainability Ratings provide value--as a way for investors to seek and evaluate stocks according to these ESG metrics.

Through the partnership with Sustainalytics, four different scores are assigned to each company. One grades the firm's environmental behaviour, another ranks its social issues activities and another grades its governance systems. These are then combined to generate an overall ESG score.

Importantly, Sustainalytics doesn't penalise certain industries for involvement in products or industries that are typically perceived as "bad". The Morningstar Sustainability Rating leaves such judgement calls to individuals, rather than trying to use an algorithmic process.

"It's about comparing companies in the same sector with their peers. We're not making a call about which companies are good or bad," Serhan says.

Courting controversy

The controversy score is a fourth grading applied during the process. Using analysis of media coverage and other public information about company activities, this is designed to identify and measure the scope of any negative incidents.

For example, News Corp's overall ranking around social issues is reduced considerably by its News of the World phone-tapping scandal.

This is an absolute grade, unrelated to the individual industry, which Morningstar applies as a deduction from the company's ESG score.

Morningstar then turns these company-level scores into a portfolio-level rating. This is done by generating an asset-weighted average of the ESG scores of companies in the portfolio, minus any controversy deductions.

In order to receive a Portfolio Sustainability Score, at least 50 per cent of a fund's assets under management must have a rating from Sustainalytics.

The Morningstar Sustainability Rating then measures this score relative to the company's category peers. These ratings follow a bell curve distribution to five groups--low, below average, average, above average and high--signified by corresponding globe icons.


Exhibit 1 Distribution of Sustainability Ratings in any given category group

Distribution of Sustainability Ratings table

Source: Morningstar


Disclosure challenges

Disclosure is a key point Serhan emphasises as a facilitator of this rating process.

"We can only do this calculation where we have the underlying portfolio. Outside of Australia, this number is close to 100 per cent," he says.

"In Australia, Morningstar holds portfolio data for around half the total listed market, around 230 companies at this stage, with this number expected to reach 300 soon."

This is reflective of the low requirement for portfolio disclosure for Australian fund managers.

"Another really important point is that these sustainability ratings should not lead an asset allocation decision ... just like you should never put together a portfolio consisting solely of our gold-rated funds," Serhan says.

"What you should think about is what your strategy is, what allocations you need ... don't let sustainability swamp what you're trying to do at a portfolio level."

Morningstar Sustainability Ratings are currently only available to retail investors via a platform accessible through a financial adviser or fund manager.

"We are working on ways of making this information more available to individual investors, but we're not in a position yet to release these. But hopefully some time before the end of the year, we will be able to do this," Serhan says.

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Glenn Freeman is Morningstar's senior editor.

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