Evaluating Mutual Funds: What You Want to Know

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Socially Responsible Investing (SRI), (also called sustainable investing; impact investing; Environmental, Social and Governance (ESG) investing; mission-based investing; faith-based investing; and other names) is a powerful tool more investors are using both to meet their financial needs and to make their money work toward their social and environmental goals. The Forum for Sustainable and Responsible Investment (US SIF) reported that in 2016 the market for sustainable, responsible and impact investing reached $8.7 trillion in assets under professional management in the US, a 33% increase since 2014. [Update: On November 1. 2018, US SIF reported that SRI assets now total $12 trillion.]

Key concerns of socially responsible investors include climate change, human rights, weapons avoidance, and corporate governance issues.

At Green America, we believe the increase in SRI assets comes as good news for people and the planet. As SRI assets grow and with a significant portion of U.S. households investing in mutual funds, it is important to understand how mutual funds are being evaluated in terms of social and environmental responsibility also called "sustainability". This blog addresses two mutual fund rating systems, one from the leading investment research and investment management company, Morningstar Inc., and the other from the socially responsible investment advisory firm--and Green Business Network (GBN) member--Natural Investments

This May, Natural Investments released the report, Rigor In Ratings: A Comparison of Morningstar’s Sustainability Rating and Natural Investments’ Heart Rating, which compares and contrasts the methodologies used by these two firms to evaluate the sustainability of mutual funds.

What Do These Ratings Rate?

As more investors become involved in SRI, it is imperative that everyone, from financial professionals to curious investors, understands how the SRI landscape is evolving. One aspect of this is understanding the difference between various mutual fund rating systems that address the environmental, social and governance (ESG) factors that mutual funds may or may not address, or address to varying degrees.

The key to using mutual fund rating systems effectively lies in understanding what the rating actually evaluates. A key part of  Natural Investment’s Heart Rating is that it considers a fund’s intention to create a more socially and environmentally just  society through actions like shareholder advocacy, extensive company screening, and community investing to support lower income populations. Morningstar’s Sustainability Rating differs in that it uses a best-in-class approach, measuring the overall sustainability performance of the holdings in a fund’s portfolio relative to the fund’s peers, without regard to “intentionality” (i.e. a stated commitment to ESG goals).

Funds in each Morningstar category, such as International Equity funds, are scored based on a bell curve in which those in the top 10 percent of scores (the best) receive five globes and the bottom 10 percent receive only one globe.  Morningstar’s Sustainability Rating uses data from the global research firm Sustainalytics.  That firm scores ESG criteria for over 6500 companies as well as “controversies” or events associated with the company that have negative ESG impacts. Morningstar uses this combination of ESG data and “controversy” data to determine a score and award globes -- the symbol for their sustainability score.

Unlike Morningstar’s Sustainability Rating, the Heart Rating does not use a bell curve but rather scores on “absolute terms of breadth and depth” of a fund’s ESG factors. In addition to awarding extra points for certain sector exclusions such as fossil fuels, the Heart Rating also considers engagement in shareholder advocacy, community investing and research capacity as part of the scoring process which also entails questionnaires and interviews with fund managers. Funds are awarded a score of 1 to 5 hearts depending on their SRI commitment and activity.

GBN spoke with Morningstar Director of Sustainability Research, Jon Hale to learn more about the thought process behind the Sustainability Rating:

“The Morningstar Sustainability Rating came from an idea I had in 2015, that company-level ESG data had become more robust over the past decade but was only accessible to a few asset managers,” says Hale. “I thought it would be useful for investors to use those company ESG scores to analyze the sustainability of mutual funds based on their holdings and do it at scale so that many funds across the world could be compared with each other.” Hale says that anyone using Morningstar’s Sustainability Rating should understand that it is a best-in-class category rating, meaning it ranks companies in the same business sector (i.e., agriculture, finance, retail, entertainment, etc.), by measuring them against each other’s combined ESG and controversy scores as noted above.

 What’s Behind the Scores

The Rigor in Ratings report highlights how the different methodologies used by the Sustainability and Heart ratings affect how funds are scored. Invesco Energy, (FSTEX), a fund with top holdings in fossil fuel companies, provides an example that could be confusing to investors who do not understand what’s behind different sustainability scores. In this example, we have a fund that received 4 out of 5 globes from Morningstar – a good sustainability rating. Many SRI-inclined investors may think a 4-globe rating would mean that this fund focuses primarily on renewable energy companies when it does not. Rather, it receives a high Morningstar rating because of its best in class score among fossil fuel-holding funds. Natural Investments, on the other hand, does not even evaluate this fund because it has no expressed intentionality regarding SRI. Interestingly, a fund dedicated to renewable energy holdings could actually have a low Morningstar score, as Hale notes: “On the flipside, a lot of the funds that do focus on renewable energy don’t get great ratings because they’re not really taking any steps to select particular stocks based on overall ESG performance of the company.”  In other words, a clean energy fund might not pay attention to a range of ESG issues and thereby receive a low Morningstar rating even though clean energy investments are in keeping with SRI values.

For Natural Investments, the intention to make progress on ESG issues is what makes or breaks a fund’s score on the Heart Rating. It’s this intentionality that researchers at Natural Investments believe is a key, missing factor in Morningstar’s Sustainability Rating.  “We don’t recommend that Morningstar only score SRI-mandated funds, we simply suggest that the highest level of their rating system be reserved for those funds that do have an SRI mandate,” says Natural Investments Managing Partner and Rigor in Ratings co-author, Michael Kramer. Kramer added: “SRI managers have explicit exclusionary screens in terms of both sectors and corporate practices and simply won’t hold certain types of companies. This is a higher standard because it takes a stronger stand about what’s ok to own and what’s not.”

Natural Investments recommends that the Sustainability Rating award more points to funds with an SRI mandate, replace the best-in-class approach with absolute criteria for all sectors, and establish minimum requirements for receiving four or five Globes.

Working Toward A Common Vision

Hale points to several significant contributions that the Morningstar Sustainability Rating has made to sustainable investing. First, he notes that the Sustainability Rating has expanded the scope and consideration of ESG criteria by a wider audience: “By in some ways, expanding the scope of what sustainability means in an investment context, I think we’ve helped expand that field for those who may not see sustainability or SRI as something that they want to make a comprehensive orientation but do want to see it reflected in their portfolio.”

The Sustainability Rating has increased awareness of ESG issues particularly among mainstream asset managers who previously, without this tool, were not, or only very minimally, integrating sustainability issues into their work with clients.

A second contribution he cites is validation of intentionally-SRI funds, since the vast majority of SRI-mandated funds receive high Morningstar ratings. Hale believes the Sustainability Rating’s methodology further confirms or validates that SRI funds are indeed walking the talk. And a third contribution is that the development of the Sustainability Rating provides an opportunity for SRI-dedicated firms, like Natural Investments and others, to clearly articulate their stance that funds should not only provide competitive returns but should also benefit society and the environment.

As it turns out, we will actually see more commonality between Morningstar and Natural Investments in the near future, as Morningstar will soon update its database to provide a closer look at what certain intentionally-SRI funds do.

“Right now in our database you can’t find information about what intentionally SRI funds do. So, we’re going to have information for the intentional funds on what screens they use, whether they engage in shareholder advocacy, and if they have any kind of impact orientation. I think that will be a really interesting improvement to our database,” says Hale.

“We’re going into a more granular assessment so people who want to look for funds that are fossil free or are impact-oriented can search for them and get a list. The results would not be an assessment of, for example, what funds are doing impact investing better than others, but it would help investors figure out where to go with intentional funds.”

Both the Heart rating and Morningstar rating provide useful information to investors seeking to better understand their mutual funds’ sustainability scores. What’s crucial is to understand the meaning of these ratings. For Green Americans seeking funds that are “intentionally SRI” and that align with their values and social and environmental goals, the Heart Rating is more likely to meet expectations. Green America is pleased to feature the Heart Rating on our website at www.greenamerica.org/socially-responsible-investing .

To find SRI investment firms, financial advisors, and mutual fund companies that are members of Green America’s Green Business Network, visit the Green Pages Online.

 

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