ESG Fund Ratings: Not Perfect, but Still Valuable

MSCI and Sustainalytics regularly communicate with the companies they assess, offering companies the opportunity to provide feedback on their assessments on an annual basis. The global response rate from companies is close to 80%, a number which has increased significantly in recent years as sustainability has emerged as a key focus area for corporations.

The development of ESG ratings systems has significantly contributed to the growth of sustainable investing. Only within the last few years have many asset managers moved to conduct this research themselves, leveraging third-party ESG research as a complement to their processes. As the integration of ESG issues in the investment process becomes more sophisticated, it becomes the user of the data’s responsibility to build on these insights, using them as a starting point.

Each asset manager has their own view on materiality and their own investment approach. The onus is on the manager to build a system and framework for considering these factors and supporting it with a sound rationale and investment thesis. We treat company-reported price-to-earnings ratios differently based on investment styles. We build our own valuation models that incorporate multiple data inputs that we adjust for various considerations. Why should the treatment of ESG data be any different? The secret sauce should be the application of the data, not the data itself.

Standardizing the Data and Ratings System

Alongside the increase in availability and quantity of ESG data, there is also a movement toward standardizing the data and ratings systems. To that end, the Sustainability Accounting Standards Board (SASB), the Task Force for Climate Related Financial Disclosures (TCFD), and others are working toward standardizing company disclosures, which will improve the quality of the data and create a common language for how companies report these metrics.

Generally Accepted Accounting Principles (GAAP) were established in 1933. Modern Portfolio Theory took hold in 1952. The Capital Asset Pricing Model came along in the 1960s. Our standard approaches for risk and return are still relatively new — and imperfect. ESG research and ratings should be viewed through the same lens. At best, we have a decade of data, and there are gaps in that data. It’s easy for investors to expect companies to disclose, be transparent and wait until the data improves. But if you do that, you’re leaving some really interesting data sets on the table that could provide valuable insights.

Our world is changing. Continuing to rely on traditional ways of evaluating risk and return just isn’t going to cut it. We need to continue to critically examine ESG data, ratings and integration techniques, but approach such scrutiny with context and through the lens of indicative and emerging evidence.

Kiley Miller is an associate portfolio manager working with impact portfolios at Envestnet.