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Higher Sustainability Ratings Can Mean Lower Risk

Jon Hale, Ph.D., CFA

There is a tendency to assume that sustainable investing is only about those who want their investments to reflect their values. But large numbers of institutional investors and asset managers are incorporating into their investment processes the consideration of how companies address material environmental, social, and governance issues not to make any kind of statement about values but because they find company ESG evaluations pertinent information that should be considered in any complete investment analysis. In a 2015 CFA Institute survey, 73% of respondents said they now consider ESG issues in their investment analysis or decisions. When asked why, most (63%) said they did so to help manage investment risks.[1]

Companies that address material issues facing their business, ranging from resource scarcity and climate change to supply-chain management, product safety, and corporate ethics, can reduce their operational and reputational risks. Information on how firms are managing their ESG risks and opportunities has been made increasingly more accessible to asset managers over the past decade as more high-quality firm-level ESG data and research has become available.

How does this play out at the portfolio level? Some have theorized that portfolios consisting of companies with higher ESG ratings must be less diversified because the universe of higher ESG-rated companies is a subset of the overall universe, and less diversification can lead to increased risk. But recent academic studies have found this not to be the case, finding that companies with better ESG ratings carry lower firm-specific risk, offsetting the impact of any loss of diversification at the portfolio level.[2]

The Morningstar Sustainability Ratings and the underlying Portfolio Sustainability Scores give us an opportunity to look at the relationship between ESG ratings and portfolio volatility. The Morningstar Sustainability Rating for funds uses company ESG ratings from Sustainalytics to assess how well the holdings in a portfolio are managing the ESG issues most relevant and material to their businesses. The Portfolio Sustainability Score is an asset-weighted roll-up of company ESG scores with deductions made for company involvement in ESG-related controversies. A fund’s Sustainability Rating reflects its Sustainability Score relative to its Morningstar Category peers.

My universe was funds in the U.S. large-value, large-blend, and large-growth Morningstar Categories that have Morningstar Sustainability Ratings. I chose these categories because most of their funds have ratings and the categories are reasonably homogeneous in terms of their investment style and other exposures. They also comprise the largest allocations in the equity portfolios of most U.S. investors.

The results show, across all three categories, that funds with better Morningstar Sustainability Ratings tend to have lower volatility. This statistically significant relationship holds whether we use the Morningstar Sustainability Ratings or the underlying Portfolio Sustainability Scores upon which the rating is based. (For simplicity, Exhibit 1 reports the results for scores only.) The relationship holds whether we use standard deviation as our measure of volatility or Morningstar Risk, which emphasizes downside variations in returns. And it holds for those volatility measures over trailing three-, five-, and 10-year time periods. The relationship is stronger for funds in the large-growth and large-value categories than it is for funds in the more homogeneous large-blend category.

To be sure, based on this evidence, we can’t claim that higher Sustainability Scores result in--or “cause”--lower volatility because our scores are calculated using current portfolios while our risk measures cover prior time periods. Today’s Sustainability Scores could not possibly have “caused” past performance. We simply can’t say how any fund would have stacked up on portfolio sustainability had we been measuring it three, five, or 10 years ago. We know for certain that the quality and quantity of ESG data on companies was much lower five to 10 years ago and that fewer managers were using it to help them make investment decisions. It will be a while before we can test the possibility that higher Sustainability Scores contribute to lower fund volatility.

On the other hand, what our findings do demonstrate is that managers of already established, lower-volatility strategies tend to have significantly higher Sustainability Scores in their current portfolios. It may be that managers of lower-risk strategies are more likely to use ESG data now that it has become more widely available because they see it as directly relevant to their investment objectives. This is consistent with the CFA Institute survey findings that more investors are considering ESG issues and are doing so mostly to manage risk.

More broadly, what these findings suggest is that companies that are doing better than their peers managing the risks posed to their businesses by ESG issues tend to be less risky and therefore tend to find their way into lower-volatility portfolios--regardless of style or even whether the manager is paying attention to ESG issues at all.

Using the Morningstar Sustainability Ratings to help you select funds can lead you to well-established lower-volatility offerings that can serve as mainstays in your portfolio over the long run. Exhibit 2 provides a list of 5-globe funds in each category that have lower risk and are recommended by Morningstar analysts as funds that are likely to outperform their peers on a risk-adjusted basis going forward. Their Sustainability Ratings provide some concrete evidence that they will remain lower-risk funds. Several on the list have sustainable/responsible mandates, so we know that considering ESG issues is fundamental to their investment process.

[1] CFA Institute, 2015. "ESG Issues In Investing: Investors Debunk the Myths."
[2] Hoepner, A.G. 2013. “Environmental, social, and governance (ESG) data: Can it enhance returns and reduce risks?” Global Financial Institute, Deutsche Asset & Wealth Management; and Verheyden, T., Eccles, R.G., and Feiner, A. 2016."ESG for All? The Impact of ESG Screening on Return, Risk, and Diversification." Journal of Applied Corporate Finance, 28:2 Spring.