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Editor’s Letter: December 2017

Morningstar’s Next Revolution.

I understand asset managers don’t always like Morningstar. They don’t like seeing their funds boiled down to a simple star rating.

I also know there’s little asset that management firms value more than good publicity, and feel fear more than bad. Negative perception can easily turn potential investors away; there’s always another fund. Some may misuse the ratings, but they were game changers in helping investors through the “grocery store” problem in funds—too much choice, not enough differentiation.

As ground-breaking as they are, I think Morningstar’s Environmental, Social and Governance ratings could be an even bigger deal; not just for product manufacturers and advisors, but also for the companies that use shareholders’ money.

That sounds grandiose. But consider their work with Sustainalytics, an ESG data firm ranking every investable company on its exposure to “non-financial factors” that might impact business performance—things like relying too much on carbon production, exploiting overseas labor markets, stacking the board of directors with the CEO’s golf buddies instead of shareholder advocates.

MSCI too has built an ESG database, as have others. And the Sustainability Accounting Standard Board is close to setting the standards for companies to disclose “material,” (i.e., potentially disruptive) ESG factors in SEC filings, giving investors more insight into what managers are doing with their money.

Still, it’s the simplicity of Morningstar’s approach that’s important. Depending on a portfolio’s aggregate ESG score, they’re assigning one- to five-star “globes” to the funds—regardless of whether the manager has an ESG mandate or not.

You don’t need a hippie’s belief in the moral value of socially responsible investing to see that most fund managers would like to avoid putting their name on a one- or two-globe fund. Who wants to advertise the fact that they are on the wrong side of the angels?

Maybe they recalibrate their holdings toward companies with higher ESG scores. Or, they explicitly take ESG rankings into their methodology.

Like a feedback loop, corporate managers see their value in the marketplace calculated in part by the ESG factors, just as it is on cash flow and p/e ratios.

Institutional investors have long used socially responsible investing to make values-based changes in the world—barring investment in companies that profit from the misery of others.

But those efforts are often geared toward specific outcomes—the Morninstar ratings may put ESG pressure on every company that comes to the public markets for financing.

Too optimistic? Or is ESG just another asset management fad? Let me know what you think. [email protected]


David Armstrong


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