The Morningstar Sustainability Rating looks at how a fund's underlying holdings measure up in the context of environmental, social and governance (ESG) factors. It is a powerful tool, one which can help meet the needs of investors searching for more sustainable investment options. However, like any other data point, the rating will not tell the full story and should always be looked at in the context of a fund's objective, investment approach, as well the peers it is measured against.
There are currently 30 Morningstar medalists across various categories that have an assigned Sustainability Rating. While the Sustainability Rating is not considered as part of our medalist ratings, we have learned a few lessons from assessing the sustainability of some of our top-rated funds.
Beutel Goodman: The proof is in the process
Gold-rated Beutel Goodman Canadian Equity and Bronze-rated Beutel Goodman American Equity are two out of three medalists that have the highest possible Sustainability Rating. Beutel Goodman's investment teams follow a disciplined investment process that includes in-depth analysis of company management and business fundamentals. This analysis can help the team focus on those companies with stronger governance structures and those less exposed to different environmental and social risks. Furthermore, Beutel Goodman also considers ESG factors by actively engaging with company management through the proxy voting process.
Because Beutel employs the same approach across its lineup, it's not surprising other large-cap funds like Beutel Goodman International Equity and Beutel Goodman Canadian Dividend have also been assigned a "High" Sustainability Rating. The same, though, isn't true for the firm in the small-cap arena.
Beutel Goodman Small Cap: Market cap matters
Beutel Goodman Small Cap has a "Below Average" Sustainability Rating. This may say more about its Canadian Small/Mid Cap Equity peer group, however, than the sustainability of its holdings. Relative to its category rivals, the fund holds a greater proportion of small caps. And Morningstar's Sustainability Rating could put smaller firms at a disadvantage.
One input of the Sustainability Rating assesses the quality of a company's disclosure practices -- an area where smaller companies have generally lagged. Disclosure is only one input of the company-level rating, and other factors could impact a fund's sustainability rating.
Because fewer small-cap stocks are rated for sustainability, funds within the Canadian Small/Mid Cap Equity category have a lower proportion of their assets rated for sustainability. As such, the rating may not paint a true portrait of a small-cap portfolio's sustainability. In the small-cap arena, it's best to take the Sustainability Rating with a grain of salt.
NEI Ethical: No guarantees with intentional ESG
NEI Ethical is one of the few Canadian investment managers which intentionally considers ESG factors. That's no guarantee of high Sustainability Ratings, however. Bronze-rated NEI Ethical American Multi-Strategy's Sustainability Rating is "Low." Because NEI hires external sub-advisors, it doesn't control funds directly but it has a dedicated team that identifies stocks that do not fulfill their ESG criteria and excludes them from the sub-advised portfolio. This winnowing process improves the portfolio's sustainability. NEI excluded nine stocks included in the March 2016 holdings of the fund's U.S.-domiciled counterpart, Manning and Napier Equity, modestly improving upon the Sustainability Score of the original portfolio.
That an NEI portfolio scores poorly on our measure of sustainability doesn't mean the firm isn't living up to its principles. Rather than avoiding all low-scoring firms altogether, NEI attempts to push its holdings to improve their ESG practices. The Sustainability Rating won't tell you whether the asset manager has been an effective ESG activist. Investors who value such activism may be able to overlook low Sustainability Ratings.
Brandes Emerging Market Value: Consistent controversy in a deep value strategy
Here's a case where a high Sustainability Rating might raise alarm bells. Silver-rated Brandes Emerging Markets Value employs a deep-value strategy, which often leads it to cheap stocks clouded by controversy. These controversies, as with the bribery scandal enmeshing holding Petrobras, are often ESG-related. The Sustainability Rating accounts for these incidents with the Portfolio Controversy Score. Not surprisingly, the Brandes fund has one of the highest controversy scores within its peer group (though its overall rating is "Average"). Had its controversy score been relatively low, it would be inconsistent with its overall investment approach and how it has positioned its portfolio historically.
CI Black Creek: Same philosophy, different ratings
Despite being managed with the same investment philosophy, Silver-rated CI Black Creek Global Leaders and CI Black Creek International Equity are at the opposite ends of the Sustainability Rating spectrum, with the former having the highest possible rating and the latter the lowest.
Because the rating is relative to category peers, it's possible for similarly managed funds to score differently if they fall in different categories. While CI Black Creek Global Leaders does hold a greater proportion of highly rated companies than its sibling, it also benefits from an easier comparison group. Fewer firms in the Global Equity universe -- which includes U.S. stocks -- score as highly on ESG grounds, giving Global Leaders a lower hurdle to jump. A higher preponderance of strong ESG practices in the International Equity arena -- which does not include the U.S. -- makes it more difficult for Black Creek International to achieve a better Sustainability Rating.
It's not entirely clear what is driving up the International Equity category average; it could be that international equity investment managers are actively choosing to invest in more sustainable companies, or perhaps the universe of international companies is more sustainable in nature. The latter is quite plausible, as European-based companies (which make up a significant portion of the International Equity funds) have scored better than companies from other parts of the world. Both the regulatory environment and market demand in Europe have pushed companies to pay attention to ESG factors and Sustainability. CI Black Creek Global Leaders' larger Europe weighting could explain some of the differences in Sustainability Rating versus its sibling.
