Tuesday 31/03/2020

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Should we be afraid of ESG ratings for SICAVs?

Responsible Investment Strategist

“Help, my fund is going to have an ESG rating!” There was quite a lot of upheaval in the investment funds and SICAVs world a few months ago. Morningstar had announced that it would expand its database with ESG ratings for funds. Based on research on ESG (environmental, social, governance) criteria conducted by Sustainalytics, the extra-financial rating agency, Morningstar will from now on be adding an ESG rating to the funds in its database. The higher a fund’s score with regard to environment, social welfare and corporate governance, the more “globes” it gets.

This announcement led to a fair bit lot of turmoil among asset managers, as this rating is related to all investment funds, except those investing in government bonds, regardless of whether they apply a sustainable investment policy and ESG criteria to their investment process. We will not rehash the issue of the lack of a definition of what “socially responsible investment” means. After all, that is a different debate, but disclosing a fund’s ESG rating might suggest that this rating should be improved, which is not everyone’s intention.

To top it all, Morningstar/Sustainalytic’s most important competitor, namely MSCI ESG Ratings, announced a similar initiative, which also looks into investment funds’ ESG quality. However, this is based on the extra-financial ESG research of MSCI ESG Ratings.

It is clear that there is stiff competition on market leadership. However, what is the objective of such initiatives at the end of the day? What is exactly behind this ESG rating, and why is the investment industry so afraid of it?

A solid and rigorous methodology

Regardless of the supplier of the so-called extra-financial information, the research resources are solid. After all, there are between 140 and 150 analysts that between them cover the various sectors and regions, to be able to analyse the companies as well as they can in terms of ESG criteria. They concentrate on the most material challenges, in accordance with their respective sectors, and allocate a rating to each of these aspects in order to rank companies from the ones which are the best prepared for ESG challenges to the ones that are the least prepared. In the responsible investment lingo, we call this a “best-in-class” approach.

The assessment process, which has existed for several years now, continuously tracks the progress made in this domain, to be able to focus on the most relevant and material criteria at all times.

However, as we mentioned in a previous blog article: the methodology for extra-financial ratings for companies and the best-in-class approach tend to have a bias towards global large caps in various respects. This tends to squeeze out small caps, in particular those in emerging markets. Of course, these biases recur in the overall rating of the investment portfolio.

My fund has three globes - is that good or is there room for improvement?

Whether the rating is attributed in the form of a number of globes (Morningstar) or a score ranging from 0 to 10 (MSCI ESG Ratings), what does it finally mean to investors?

Probably not an awful lot. After all, the rating pertains to the weighted average of the ratings of individual companies which were analysed.

First and foremost, as with any average, it is perfectly possible for a portfolio to be invested in companies with extreme profiles - in other words, the worst ranked companies in terms of ESG challenges and the companies which are the best positioned in that regard - and that this results in the same average as a portfolio which would not invest in any company in the bottom of the ESG ranking, but which would be content to invest in companies exhibiting a reasonable ESG profile.

Furthermore, the follow-up of the underlying securities also plays an important role. Indeed, only the companies which are being covered by the research agencies are taken into account, and the rating of the covered companies is thus reduced to the portfolio’s total score. In other words, if you are invested in a portfolio consisting of four multinationals with the means to fill out the questionnaires and which meet the requirements and criteria of independent research agencies, and also of twenty-five Belgian and foreign small caps which are not widely covered, your investment’s rating will ultimately be that of the four large multinationals. That can be quite high. Conversely, a portfolio which is invested in a few mid-caps, which generally obtain lower scores, will exhibit a lower overall portfolio rating as it may contain companies which are pioneers in terms of environmental or corporate sustainability. This results in specific portfolios with large investments in oil companies obtaining a better rating than portfolios invested in small caps which innovate in specific sustainability domains.

Moreover, we should also consider the category in which your investment fund is located. For example, a global fund primarily investing in developed markets is likely to have a better rating than a fund which also invests globally, but which has higher exposure to emerging markets, as there is a strong correlation between the level of disclosure and ESG quality. The more a company reports on ESG information, the higher the ESG quality. There is an attempt to standardise ESG models, but this is not always suitable for every portfolio and every strategy. If the score is boiled down to a quantitative assessment (globes or a score ranging from 0 to 10) and comparisons are made, the granularity of the information decreases and the diversity of the investment approached may be less distinctive.

Finally, this can also result in a conflict of interest, whereby extra-financial rating agencies refrain from attributing low scores to companies that are among their clients. That risk is lower, however, as the extra-financial rating agencies are generally remunerated by the investment companies using their research for their investment processes. The companies being analysed do not remunerate the rating agencies, and have the right to give feedback on the rating and the controversies they are accused of facing.

The advantage of the approach... more transparency and awareness

Although the approach is facing strong criticism from the asset managers who after all “had not asked for anything”, it has two advantages. Firstly, by disclosing a specific rating - having a certain value - people will take a moment to think about its usefulness, origin, meaning and reason for being. As a result, investors will reflect more on the integration of the criteria in terms of environment, social wellbeing and corporate governance in investment decisions.

Secondly, even though it may be simplistic to some extent, it also fosters increased transparency, which can only be good news for investors in the medium to long term. Thanks to this additional information and transparency, responsible investment, which aims to systematically integrate ESG criteria in investment decisions, is making inroads in all kinds of investments. This means that the financial industry is taking these criteria into account more, with a greater leverage effect as a result.

Responsible investors also have the duty to suggest improvements, and to challenge rating agencies on their rating process. In this way we can together stimulate a responsible financial system geared towards the medium and long term.