Sustainability Ratings Tank Fund Performance

Attempts by mutual funds to improve their Morningstar sustainability ratings in order to attract more investor dollars led to lower performance ratings.

Attempts by mutual funds to improve their Morningstar sustainability ratings in order to attract more investor dollars led to lower performance ratings. This observation was reached after an analysis was conducted of how the introduction of the Morningstar sustainability, or “globe,” ratings altered mutual funds’ allocations.

Initially, mutual funds increased their demand for sustainable stocks, but the behavior created buying pressure for stocks with higher sustainability ratings and caused them to become overvalued. This, in turn, led to their Morningstar star ratings being downgraded.

The study’s authors explained the difference between Morningstar’s globe rating and their star rating. “The Morningstar star ratings were first introduced in 1985 and represent a quantitative backward-looking measure of a fund’s performance, ranging from one (low) to five (high) stars. The star rating is based on a fund’s percentile rank relative to peer funds in the same Morningstar category.” In regard to the sustainability ratings, they wrote, “On March 1, 2016, Morningstar introduced ratings aimed at ranking the sustainability of the funds’ portfolios. The objective was to provide a way for investors to evaluate how different funds meet environmental, social and governance standards. These ratings were introduced side-by-side with the star ratings and are referred to as globe ratings. They range from one (low) to five (high) globes.”

Included in the study’s sample were all U.S. domestic equity funds with at least $10 million in assets under management that were at least two years old. The parameters also required funds to have return, age and expense ratio information, in addition to a Morningstar category and star and globe ratings. The analysis from March 2016 to December 2017 included 6,680 share classes from 1,953 funds.

The study’s authors concluded: “Rating financial intermediaries on the basis of sustainability of their portfolios may appear to be an effective mechanism that allows investors to allocate their funds in accordance with their environmental and social preferences. We show that if most investors care to an even larger extent about performance, a trade-off between portfolio sustainability and performance may arise and reduce the subsequent effectiveness of sustainability ratings.”

Although the purpose of the sustainability ratings was to rate funds on their environmental and social responsibilities, the funds’ attempt to increase their ratings had a detrimental effect on performance. A more gradual approach to increasing a fund’s globe rating should be considered.

Source: “Sustainability or Performance? Ratings and Fund Managers’ Incentives,” by Nickolay Gantchev, Mariassunta Giannetti and Rachel Li; SSRN, November 2020.