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How Fund Investors Use Sustainability Ratings

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Mutual fund and ETF Investors are using sustainability ratings primarily as a negative screen to avoid certain investments rather than a positive one that attracts their money, according to a new Morningstar report. It also found that investors do not give as much weight to ESG scores as other measurements of sustainability.

Morningstar analysts studied investor flows into and out of funds based on three metrics:  fund sustainability ratings, ESG controversy scores and ESG factors, over the period from March 2016 to June 2018, to test the impact of these ratings on investors’ choices.

They found that funds with a one-globe rating for sustainability — the lowest in a rating system with one to five globes — experienced a growth rate that was 3.7% lower than what would have been expected given a fund’s  expense ratio, size, age, alpha and active or index management. In contrast, funds with four and five globe ratings experienced flow that were 1.5% and 1.4%, higher.

“This indicates investors strongly avoid funds that are rated poorly from a sustainability perspective and do so more strongly than they are dawn to funds that are rated more highly,” write analysts Daniel Kleeman and Madison Sargis.

Fund investors are like portfolio managers who avoided “sin stocks” in the early days of ESG, which “suggests that ESG for fund investors is less mature than for professional portfolio managers.”

Fund investors also avoided funds with the highest ESG controversy scores or pulled more money from those funds, which illustrates the negative impact of financial scandals or data breaches, according to the Morningstar report.

That avoidance, in turn, puts pressure on asset managers, as exemplified by BlackRock’s announcement that it was looking into ways to move out of funds with firearm stocks following the Parkland, Florida school shooting.

(Related:  6 Steps for Money Managers to Better Incorporate ESG Investing)

Portfolio ESG scores were the least important measure for investors concerned with sustainability, according to the Morningstar report. These scores, based on a company’s preparedness, disclosure and management approach to addressing ESG factors, had little impact on investors’ choices when considered in isolation. “Across all funds, growth rates did not vary with a fund’s Portfolio ESG,” the authors write.

(Related: Understanding ESG Ratings: A Brief Primer From Celent)

When combined with another sustainability metric, however, they did affect investors’ choices. The researchers found that Investors were less likely to sell out of a fund with a one globe sustainability rating if the fund had a high ESG score even though one globe funds on average had slow flow growth rates.