Third-party ratings aimed at quantifying the overall “sustainability” of investment funds do not tell the whole story and should not be viewed in isolation according to Kames Capital.
Georgina Laird, Sustainable Investment Analyst at Kames Capital, says newly launched sustainability ratings can play an important role in making the consideration of sustainability more mainstream among investors, and prove useful to them when seeking to incorporate ESG risks into a broader investment process, but they should only be considered alongside other factors.
And Laird warns that when applied to funds with a more niche sustainability remit or theme, “these ratings risk being misunderstood”.
“Whilst the ratings agencies take a similar approach to one another in quantifying sustainability, they can arrive at very different conclusions for the same companies,” she says. “Recognising that different approaches can result in different conclusions is vital for investors to understand before relying on the ratings as evidence of how sustainable a company or fund is.
“As we understand it, the various rating methodologies have already been amended numerous times. We hope that a number of additional points will be considered, and that they will be of use to investors seeking to incorporate ESG into their process.”
Below, Laird sets out three factors to consider alongside the ratings of the agencies, giving greater context to the investors using them.
“It is important to understand that many of these ratings focus on the practices of a company with less consideration given to the sustainability of the products or services they provide. By focusing only on the operational aspects, the ratings can attribute strong sustainability credentials to companies whose products may have adverse effects on society – for example tobacco and weapons manufacturers.
“In our view it is important to consider three dimensions when assessing sustainability. The first is ‘product’. What is a company making and what are its societal effects? The second is ‘practices’. How efficient are the company’s operations? Finally, ‘improvement’. How is a company improving its sustainability efforts over time?”
Peer group definitions and ‘intentionality’
“One provider now rates conventional funds according to its ESG / Sustainability performance. While this is interesting, it risks being misused or misunderstood. The provider makes relative comparisons within specific peer groups. However in doing so, a fund with a sustainability remit can easily ‘appear’ worse than a conventional equity fund.
“We do not feel that the defined peer groups capture the necessary element of the ‘intention’ of the fund. A fund which scores highly in terms of ESG ratings does not necessarily provide positive social or environmental benefits. Likewise, an environmentally focused fund may not score highly in terms of ESG. The fund level sustainability ratings are useful when incorporated into the broader investment process, but more niche funds can be sorely misconceived.
“We would encourage a more explicit definition of peer groups be made available by the rating agencies to assist users in understanding the context of the ratings. We would also recommend that the peer groups consider the intention of the fund, allowing for a more comparable set.”
Market cap and location
“Higher ESG scores are highly correlated with market capitalisation: larger companies have more resources available to measure and report on sustainability. Smaller companies have poorer preparedness and disclosure and, as a result, often receive lower ESG ratings. There is also a lack of coverage of smaller cap companies, which can skew the overall sustainability rating of portfolios further.
“Moreover, there is a strong correlation between ESG rating and geographical location. Europe is a leading continent, with much more developed sustainability regulations and reporting than the US and Asia. As a result, funds overweight in European companies often score better.
“Whilst these factors are considered by the ratings agencies, we do not believe these issues can be ironed out completely. It is important for investors to blend a qualitative approach alongside use of sustainability ratings, to ensure these particular nuances are captured. We often engage with companies to overcome these size and location biases, and to attain a better understanding of a company’s overall efforts.
“We believe the ratings agencies should consider the qualitative aspects of an integrated sustainability process into their methodology. Sustainability is not, and cannot be, just another dataset.”