Morningstar Sustainability Rating Definition and How It Works
Contents
- 1 Morningstar Sustainability Rating: Definition and How It Works
- 1.1 What Is the Morningstar Sustainability Rating?
- 1.2 Understanding the Morningstar Sustainability Rating
- 1.3 Rating Methodology
- 1.4 Morningstar Star Rating vs. Sustainability Rating
- 1.5 Sustainable, Responsible, and Impact Investing Alternatives
- 1.6 What Is a Good Morningstar Sustainability Rating?
- 1.7 Which Companies Provide ESG Ratings?
- 1.8 Which Company Has the Best ESG Report?
- 1.9 The Bottom Line
Morningstar Sustainability Rating: Definition and How It Works
What Is the Morningstar Sustainability Rating?
The Morningstar Sustainability Rating compares mutual funds and exchange-traded funds (ETFs) based on environmental, social, and governance (ESG) standards.
Introduced in 2016, the Morningstar Sustainability Rating uses five “globes” to indicate a fund’s ESG standing within its industry group, ranging from one (lowest) to three (average) to five (highest). Ratings are issued monthly.
Key Takeaways
- The Morningstar Sustainability Rating helps investors evaluate funds based on environmental, social, and governance (ESG) characteristics.
- Ratings are expressed using a five-globe system, with one globe being the lowest score and five globes the highest.
- Sustainability ratings are based on the risk ESG factors pose to a fund’s holdings.
- Each company in the portfolio is graded on a scale of 0 to 100 relative to its industry peers.
- At least 67% of a portfolio’s assets under management must have a company ESG score for the portfolio to obtain a sustainability score.
Understanding the Morningstar Sustainability Rating
The Morningstar rating system was created due to the growing importance of sustainability in investment decisions.
Companies are rated relative to their global peers, meaning two firms with the same score but belonging to different peer groups may not have equivalent ESG performance.
The ratings are based on research by Morningstar’s Sustainalytics firm and its ESG risk ratings, which measure the risk ESG factors pose to a company’s value. Each company is graded relative to other firms in its industry peer group on a scale of 0 to 50—the lower the score, the better.
67%
To receive an ESG score, at least 67% of a portfolio’s assets under management must have a company ESG score.
Rating Methodology
The Morningstar Sustainability Ratings are derived through a five-step process:
- Determine the fund’s suitability for a rating: At least 67% of the companies in the portfolio’s assets under management must have an ESG score for the portfolio to receive a sustainability score. The Morningstar Sustainability Rating adjusts the portfolio score by subtracting points for ESG-related events such as oil spills or discrimination lawsuits.
- Calculate corporate and sovereign sustainability scores: Two separate assessments are used for corporate and sovereign sustainability scores. Corporate sustainability scores measure how ESG factors affect a company’s value, while sovereign sustainability scores assess a country’s socioeconomic condition and resource management.
- Calculate the historical scores for corporate and sovereign sustainability: The fund’s overall sustainability risks are calculated using a weighted average of the previous 12 months of each fund’s score, with more recent outcomes given more weight.
- Rank each fund’s corporate and sovereign historical sustainability scores: Each fund’s scores are compared to all scored funds in the same Morningstar category. To receive a rank, at least 30 funds in that category must be eligible.
- Assign ratings: Morningstar assigns ratings for corporate and sovereign sustainability based on each fund’s rank within its category, with the ratings ranging from 1 (lowest risk) to 5 (highest risk).
Distribution | Rating |
Best 10% (lowest risk) | 5 |
Next 2.5% | 4 |
Next 35% | 3 |
Next 22.5% | 2 |
Worst 10% (highest risk) | 1 |
Morningstar calculates the final sustainability rating by adjusting and summing up the weighted corporate and sovereign sustainability scores, rounding the result to the nearest whole number.
Morningstar Star Rating vs. Sustainability Rating
Funds with higher sustainability ratings generally hold higher-quality holdings. These funds are favored by Morningstar analysts, tend to be less volatile, and have greater exposure to financially healthy companies with economic moats.
However, a fund can have high star ratings and a low sustainability rating. For example, Fidelity’s Total Market Index Premium fund received a four-star rating for its risk-adjusted returns and was praised as a choice for diversified exposure to U.S. stocks. However, it only had a sustainability rating of two globes (below average).
Sustainable, Responsible, and Impact Investing Alternatives
Morningstar’s sustainability ratings provide an alternative to sustainable, responsible, and impact (SRI) funds. SRI funds have limitations, such as representing a small portion of the overall fund universe and a hesitancy from retail investors to invest in them.
Using Morningstar’s ratings can help both retail and institutional investors choose between funds. For example, when selecting two large-cap growth funds with similar performance and strategies, the sustainability rating may be a deciding factor.
What Is a Good Morningstar Sustainability Rating?
The higher the rating, the better. Five globes indicate a very ESG-friendly fund, while one globe is the worst score. An average score is three globes, making four globes a good sustainability rating.
Which Companies Provide ESG Ratings?
In addition to Morningstar, other firms that provide ESG ratings include MSCI, Bloomberg, Refinitiv, and credit rating agencies like Moody’s, S&P, and Fitch.
Which Company Has the Best ESG Report?
The best ESG report depends on the ranking method preferred. Morningstar relies on Sustainalytics to analyze ESG and corporate governance and publish its list of top-rated ESG companies. U.S. firms on the 2024 global top-50 list include the Inter-American Development Bank, Keysight Technologies, and Universal Display.
The Bottom Line
Investors are increasingly considering ESG characteristics when choosing where to invest their money. The Morningstar Sustainability Rating addresses these demands by assessing how stocks held by funds perform in these areas.
Qualifying mutual funds and ETFs receive a rating of one to five based on how the companies they invest in rank in terms of ESG within their industry peer groups. A higher Morningstar Sustainability Rating indicates a more ESG-friendly fund.