Morningstar Sustainability Rating: Definition and How It Works

What Is the Morningstar Sustainability Rating?

The Morningstar Sustainability Rating is a reliable and objective way for investors to see how thousands of mutual funds and exchange-traded funds (ETFs) are meeting environmental, social, and corporate governance (ESG) challenges.

Introduced in 2016, Morningstar’s Sustainability Ratings are expressed using a five-globe system indicating whether the investment is at the bottom end of the rating for its industry group (one globe), below average (two globes), average (three globes), above average (four globes) or at the high end (five globes) of its industry group rating. Investors can find Morningstar’s sustainability ratings on the right-hand side of morningstar.com’s fund quote pages. The Morningstar Portfolio Sustainability Ratings are issued monthly.

Understanding the Morningstar Sustainability Rating

Morningstar’s development of this rating system reflects the dramatic increase and importance of sustainable investing.

its sustainability ratings are mainly based on Sustainalytics' ESG Risk Ratings, which essentially measure the degree to which a company’s economic value (enterprise value) is at risk from ESG factors. Each company in the portfolio is graded on a scale of 0 to 100 relative to other firms in its global industry peer group. The lower the score, the better.

At least 67% of a portfolio’s assets under management (AUM) must have a company ESG score for the portfolio to obtain a sustainability score. The Morningstar Sustainability Rating then takes the portfolio’s score and subtracts points for controversial ESG-related issues that companies in the portfolio may have. Controversies include incidents that impact the environment and society, such as oil spills, discrimination lawsuits, or events that affect the company.

Morningstar Star Rating vs. Sustainability Rating

According to Morningstar, funds with higher sustainability ratings tend to have higher-quality holdings. By higher quality, Morningstar is referring to funds with five-globe sustainability ratings that are more likely to have high star ratings for their risk-adjusted returns, are more likely to be favored by Morningstar analysts, are less volatile, and have more exposure to financially healthy companies with economic moats.

However, a fund may have a high star rating and a low sustainability rating. For example, Fidelity’s Total Market Index Premium fund (FSTVX) was given a four-star Morningstar rating out of five for its risk-adjusted returns. Morningstar’s premium analyst report called this fund “a great choice for diversified exposure to U.S. stocks of all sizes” thanks to its low cost and its “broad, market-cap-weighted coverage of the U.S. market.” It also carried a gold rating, indicating that analysts expect the fund to outperform over a full market cycle of at least five years. However, it only had a sustainability rating of two globes out of five (below average) based on an 80% ranking in its category and a sustainability score of 45.

SRI Fund Alternative

Morningstar’s Sustainability Ratings make it possible for investors to tilt their portfolios toward a sustainable investment philosophy without having to purchase sustainable, responsible and impact (SRI, formerly socially responsible investing) funds. SRI funds have several potential shortcomings: they represent a small percentage of the fund universe and studies have both proven and disproven their ability to offer higher returns compared to their non-SRI counterparts. As a result, many investors are hesitant to invest in SRI funds. In addition, investing in SRI funds can lead to overexposure in some sectors and underexposure in others.

Investors may be more inclined to choose one traditional fund over another based on the relative Morningstar Sustainability Ratings. If an investor is choosing between two large-cap growth funds with similar long-term performance and investment strategies, and one has a two-globe rating and the other a four-globe rating, the globe rating may be the deciding factor.

The Bottom Line

Investors are increasingly paying more attention to environmental, social, and governance (ESG) factors, such as climate change, how employees are treated, and executive pay. The Morningstar Sustainability Rating addresses these demands by essentially telling investors how the stocks held by funds behave in these areas.

Qualifying mutual funds and ETFs are given a rating of one to five based on how the companies they invest in rank in terms of ESG within their industry peer groups. The higher the Morningstar Sustainability Rating, the more ESG-friendly the fund.