Is there a relationship between Morningstar’s ESG ratings and mutual fund performance?

ABSTRACT

We analyze the relationship between Morningstar’s ESG ratings and the performance of 146 mutual funds domiciled in Norway. Dividing the sample into ESG quintiles, we find no evidence of rating level effects, nor do we find any abnormal risk-adjusted returns (alphas). However, there is a recurring notion of a geographical bias in the distribution of sustainability ratings. Analyzing the European categorized funds separately, we find significantly higher returns and (positive) alphas for the top ESG quintiles. Furthermore, we find evidence of an ESG momentum effect in the way that performance improves in parallel with improved ESG ratings. Taken at face value, this indicates that there may be a financial reward from tilting investments towards European companies with high ESG rating or in general investing in companies with a low ESG rating and, as an active owner, contribute to an improvement of the fund’s rating.

KEYWORDS:

• ESG
• socially responsive investing
• fund performance

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1 We are most grateful for very good and constructive comments and suggestions from the JSFI’s two anonymous referees. The usual disclaimer applies!

2 UN supported network of investors working towards the incorporation of ESG-factors in international markets. PRI launched in 2006 and has since then gathered 1800 signatories worldwide, accounting for more than $70 tn AUM. https://www.unpri.org/about-the-pri

3 GSIA – Global Sustainable Investment Alliance (2016) 2016 Global Sustainable Investment Review. Available at: http://www.gsi-alliance.org/wp-content/uploads/2017/03/GSIR_Review2016.F.pdf.

4 https://www.sustainalytics.com/about-us/#History.

5 Global Sustainable Investment Alliance – Global sustainable investment review. Available at: http://www.gsi-alliance.org/wp-content/uploads/2017/03/GSIR_Review2016.

6 The Forum for Sustainable and Responsible Investment – SRI Basics. Available at: https://www.ussif.org/sribasics.

7 Eurosif – The European Sustainable Investment Forum. GSIA. Available at: http://www.eurosif.org/our-network/gsia/.

8 Global Reporting Initiative, founded in 1997, created to empower decisions that create social, environmental and economic benefits for everyone. Global Reporting Initiative – About GRI. Available at: https://www.globalreporting.org/information/about-gri/Pages/default.aspx.

9 The International Integrated Reporting Council is a global coalition of regulators, investors, companies, standard setters, the accounting profession and NGOs, whose mission is to establish integrated reporting as the norm in public and private sectors.

10 https://www.msci.com/esg-ratings.

11 The Morningstar Sustainability Rating. Helping Investors Evaluate the Sustainability of Portfolios. https://www.morningstar.com/content/dam/marketing/shared/pdfs/sustainability/IWM17NovDec-MorningstarSustainabiltyRating.pdf?cid=EMQ.

12 https://www.sustainalytics.com/about-us/#History.

13 Sustainalytics operates with 5 categories, as they exclude category ‘0’, while Morningstar lists 6 categories. This has no implications in practice.

14 Scale where severity (score deduction) increases exponentially with categories.

15 The Morningstar Global Category classifications can be found here: https://www.morningstar.com/content/dam/marketing/shared/research/methodology/860250-GlobalCategoryClassifications.pdf.

16 https://www.morningstar.com/articles/891279/interpreting-the-morningstar-sustainability-rating.html.

17 https://www.morningstar.com/content/dam/marketing/shared/research/methodology/744156_Morningstar_Sustainability_Rating_for_Funds_Methodology.pdf.

18 https://arabesque.com/research/ESG_for_All.pdf.

19 https://www.oslobors.no/ob_eng/markedsaktivitet/#/details/OSEFX.OSE/overview.

20 Changes in controversy scores can affect persistence as they take place as a function of controversial incidents and has the potential (in severe cases) to affect the superior score in a larger degree than other sub-scores.

21 For the remainder of this paper, ‘high sustainability’, ‘top quintile’ and ‘High’ (capital H) are interchangeable terms, referring to the top 20% sustainability portfolios. Likewise, ‘low sustainability’, ‘bottom quintile’ and ‘Low’ (capital L) refers to the bottom 20% sustainability portfolios.

22 The appraisal ratio is a measure for excess performance to the ‘residual standard deviation,’ i.e. what remains after subtracting market risk. $\mathrm{A}\mathrm{R}=\left(\alpha /{\sigma }_p\right)$.