Handle With Care: The Role of Third-Party ESG Ratings Providers in the Fund Selection Process
While ratings can be a helpful tool to identify and understand potential environmental, social and governance (ESG) risks and opportunities, we believe they should be just one of several tools used to implement ESG investing.
In recent years, ESG ratings providers proliferated, including a mix of firms both familiar and new, such as MSCI, Morningstar, Refinitiv, Bloomberg and FTSE. ESG ratings providers are an increasingly prevalent input for ESG investing, with recent studies showing the portion of invested assets that rely on ESG ratings has increased by 34% since 2016.1 Additionally, in the first quarter of this year, ESG designated funds, many of which construct their portfolios based on third-party ESG ratings, experienced record inflows.2
Methodology differences from one ESG ratings provider to the next create challenges for advisers and investors who use these ratings to achieve financial return and manage risk.
What’s in a Rating?
While most ESG ratings providers generally employ a single-score approach (i.e., assigning a security or fund with a rating) the methodology by which this score is determined varies. Consider the following:
- ESG investing often involves considering risks or opportunities that are intangible and difficult to measure (e.g., how a company treats its workforce).
- Standardized data is more challenging to obtain as it relates to E, S and G factors compared with traditional financial metrics. Providers may use different data sources as inputs into their rating, which can result in varying outlooks for a company across ratings providers.
- One ratings provider may place more emphasis on one E, S or G factor compared to other providers.
- ESG ratings are often backward-looking and some may not consider recent progress a company has achieved to improve its ESG profile.
The above factors, among others, make it challenging to accurately use the one-size-fits-all approach most ESG ratings providers employ when evaluating securities or funds. As a result, many ESG ratings providers disagree with each other on their views of certain companies.
The methodology differences among ESG ratings providers create challenges for advisers and investors who use ESG ratings to achieve financial return and manage risk. While the term “rating,” as it is typically used in financial services, connotes an objective and fact-based view, the dispersion in ESG ratings providers demonstrates that this is not necessarily the case when it comes to ESG investing. Understanding how investment managers may use third-party ESG ratings when making investment decisions is an important consideration for advisers and investors. Furthermore, it is a good practice for advisers evaluating ESG investments to familiarize themselves with the methodologies employed by the various ESG ratings providers to help clients make educated decisions to meet their sustainability-related goals.
Advisers can play an important role in helping investors understand what an ESG rating captures, as well as what it might be missing.
Moving Beyond ESG Ratings
Because ESG ratings from third-party providers have inherent limitations and biases, it is important for advisers to have additional inputs in evaluating an investment manager’s approach to incorporating ESG factors in the investment decision-making process.
What Does MFS Think?
Ratings can be a helpful tool for advisers and investors to identify and understand potential ESG risks and opportunities. That said, MFS believes ratings should be just one of several tools used to implement ESG investing.
As ESG investing continues to grow in assets and popularity, as we believe it will, advisers can play an important role in helping clients understand what an ESG rating captures, as well as what it might be missing. It is crucial for advisers to develop their own processes for evaluating investment managers’ approaches to ESG investing, which can include third-party ESG ratings, among other qualitative inputs. We believe this holistic approach to evaluating ESG investments can be another way advisers demonstrate their value to clients.
1 Source: Berg, Florian and Kölbel, Julian and Rigobon, Roberto, Aggregate Confusion: The Divergence of ESG Ratings (May 17, 2020). Available at SSRN: https://ssrn.com/abstract=3438533 or http://dx.doi.org/10.2139/ssrn.3438533.
2 Source: Morningstar, Reuters https://www.reuters.com/business/sustainable-business/sustainable-fund-inflows-hit-record-high-q1-morningstar-2021-04-30/.
The views expressed are subject to change at any time. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading intent on behalf of any MFS investment product.
Please keep in mind that a sustainable investing approach does not guarantee positive results.
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MFS Fund Distributors, Inc., Boston, MA
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