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Morningstar ratings to begin incorporating ESG risk next month

According to Morgan Stanley report, the only statistically significant underperformance of sustainable strategies occurred nearly a decade ago

Oct 4, 2019 @ 4:53 pm

By Jon Hale

Every day I see more evidence that sustainable investing is taking hold. Glancing at CNBC last month, there was Josh Brown exclaiming that "ESG and people investing in a socially responsible way is the megatrend of our generation and younger." Back at my desk, the tower of ESG reports that I have every intention of reading has grown unstable, threatening to topple.

At the top of the pile was a recent Morgan Stanley report on performance. It caught my eye because it used Morningstar fund and separate-accounts data to examine the performance of sustainable investment strategies. Going back to 2004, it finds that sustainable strategies have produced returns in line with traditional strategies. The only statistically significant underperformance of sustainable strategies occurred nearly a decade ago, in 2010, and again back in 2004, while the most significant outperformance happened in 2017. This is consistent with a mountain of research on the topic that has demolished the myth that sustainable investing underperforms.

But the big story in this report is about risk. When Morgan Stanley looked at downside risk, they found sustainable strategies consistently exhibited about 20% less volatility than traditional strategies, a finding that was statistically significant in 14 of the 15 years covered by the study.

Threats related to ESG issues are something that all investors should care about. Corporations today face unprecedented risk related to the climate crisis and its environmental impact, their use of water and other natural resources, how they treat workers throughout their supply chain, and the safety and usefulness of their products. Businesses also now operate in a radically transparent world in which they no longer have the control they once had over public information about their business.

Thanks to the internet, such information is widely available to experts and nonexperts alike to interpret and disseminate worldwide at lightning speed. It all adds up to great expectations for public companies to be good stewards of the environment, to attend to the well-being of all their stakeholders, and to govern themselves in an ethical and transparent way. At a time when a significant amount of the value of public companies can be attributed to intangible assets, including brand, reputation, and employee talent, companies can ill afford to ignore their ESG risks.

[Recommended video:Advisers should discuss ESG with wealthy clients before someone else does]

New framework

Nor can investors afford to ignore ESG risks, whether they consider themselves sustainability-minded or not. Our colleagues at Sustainalytics have introduced a new framework for evaluating ESG risk at the company level and, this November, our Morningstar Sustainability Rating for funds will reflect the new framework. Investors will now be able to see how much ESG risk is embedded in fund portfolios compared to peers. They'll be able to select funds with lower ESG risk and fund managers themselves will have a ready measuring stick that shows how well they are mitigating ESG risk in both absolute terms and relative to peers.

If risk is one watchword of sustainable investing, impact is the other. That other Morgan Stanley study I mentioned earlier was about interest in sustainable investing. The finding: It's sky high. When the first version of the study came out in 2015, I was astounded to see that 71% of respondents said they were interested. Four years later, it's up to 85%. And even more telling is the increase in those who say they are "very interested," which has jumped from 19% to 49%. Among millennials, interest is 95%, with 70% being "very interested."

Register now for our ESG & Impact Forum at the U.N. on Dec. 5.

The big reason for this interest is not only about mitigating risk, it's about raising the bar on what investing is all about. Making a difference through one's investments resonates with people. Funds that practice active ownership through engagement and proxy voting can help the companies they own meet their sustainability challenges and lower ESG risk, while creating positive societal impacts beyond financial returns.

Jon Hale is Morningstar's global head of sustainability.

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