What You Need to Know about Fund Sustainability Ratings

June 20, 2018

Given the choice between two funds that have similar returns, many people prefer to invest in the one that prioritizes investing in companies that have good environmental practices, good governance or are committed to data security or equality.

Sustainable ratings for mutual funds can help you find these kinds of funds, but because most of these ratings are fairly new, many investors aren’t sure how to use them effectively.

Sustainability fund ratings were a major topic of conversation in our recent webinar with FundX Portfolio Manager Avani Rau and Morningstar’s Director of ESG Solutions Tanya Svidler. Rau and Svidler offered practical insights on what ratings really measure, how you can access them, and, most importantly, how to put them to work in your portfolio.

Here are four things you need to know about fund sustainability ratings:

1. What’s the cost? Some ratings are free; others are not

Morningstar globe ratings indicate how an investment fares in its industry group. They’re  available for free at Morningstar.com and even at Yahoo Finance. “We really aim to make those as widely available as possible,” Morningstar’s Tanya Svidler said.

“What is not free is access to more detailed, more granular information,” Svidler said. “So for those clients who are building out investment portfolios and might require a deeper level of information and company-level related statistics–that would actually come at an extra cost.”

2. What do ratings measure? Ratings are based on potential risks, not returns

Morningstar’s ratings assess a fund’s underlying holdings using environmental, social and governance (ESG) characteristics using research and analytics from Sustainalytics.

The ratings “are very much risk-based,” Svidler explained. “The idea is to really identify long-term risks and to identify those players that are doing a better job versus the rest of the industry with regard to management of those long-term risks.”

It’s important to remember that “sustainability ratings are portfolio based, not performance based,” FundX’s Avani Rau explained. A fund could have a great sustainability rating even though it hasn’t performed well.

3. How do I use these ratings to find funds? Some ratings are category specific

Morningstar’s globe ratings are specific to a fund’s Morningstar category. “Funds are compared against their respective Morningstar retail category peers, so that U.S. large-cap value funds are compared against other U.S. large-cap value funds etc,” Svidler noted.

This is great if you know that you want to invest in a U.S. large-cap value fund, but if you’re trying to choose between a U.S. large-cap fund and a foreign fund, the globe ratings aren’t going to give you the apples-to-apples comparison you need.

Morningstar Portfolio Sustainability Scores, on the other hand, aren’t based on fund’s category, so they can be used to make broader investment decisions.

 4. How do ratings fit into my strategy? Ratings can enhance your process

Sustainability ratings can enhance your current investment process by giving you more funds to choose from, but ratings aren’t intended to replace your process.

“It’s really just one of the factors that investors need to look at,” Svidler said. It’s designed to complement your existing strategy.

“We already have a system in place for fund selection,” Rau said, and we’ve integrated Morningstar’s sustainability scores into this process.

The takeaway here is that there’s a lot to like about fund sustainability ratings. They give you a larger universe of sustainable funds to choose from, and you get access to data that you probably didn’t have before.

However, as you can see, sustainability is just one of many considerations you’ll want to make when you’re selecting funds. You’ll also want to focus on a fund’s risks and returns, and you should seek out funds that can help you build a diversified portfolio. It also helps to have a process that prompts you to check on your funds over time to make sure they continue to meet your standards.

This post by FundX President Janet Brown initially appeared on Forbes.

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