Morningstar - Q4 2021 - 44

Strategies
Shedding Light on Sustainable Stocks
An early look at Sustainalytics'
ESG Risk Rating.
Research
48
Supply Chains Break Under Pressure
53 Who's Helping Fund Managers Manage?
Quant U
57
Aligning Clients and Portfolios
Best Ideas
63 Manager: Many Strengths
64 Passive: Risk Diversifier
65
Equity: A Rare Bargain
RESEARCH
James X. Xiong
Note: A longer version of this paper (Xiong 2021) is
published in the Fall 2021 issue of The Journal of
Impact & ESG Investing.
Incorporating environmental, social, and
governance factors into the investment process
is now an accepted practice, propelled by
increasing interest in sustainable investing. To
help investors identify financially material
ESG-related risks and assess how they might affect
long-term performance, Sustainalytics
developed the ESG Risk Rating, which measures
a company's exposure to ESG risks and how
well it manages those risks. It also allows
investors to compare companies across different
industries or sectors.
The new ESG Risk Rating has the potential to be
an important tool to help investors identify the
severity of ESG risks in their portfolios and
make improvements. I took an early look at its
characteristics and performance.
A New View of Risk
Sustainalytics, a Morningstar-owned company,
released the methodology for the ESG Risk
Rating in October 2018 and launched the rating in
September 2019, first in Morningstar Direct,
replacing an older ESG measure.1
Because
I wanted to analyze a period longer than the
two-year history of the ESG Risk Rating, I created
a back-test using U.S. stocks that received
the old rating from August 2009 to August 2019.
Next, I examined basic characteristics of the ESG
Risk Rating. I wondered, does a stock with
a low ESG Risk Rating tend to be larger and more
expensive than its counterparts? To address
1 For a more detailed explanation of the ESG Risk Rating, see https://www.sustainalytics.com/esg-data.
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Morningstar Q4 2021
I recalculated the ratings for these stocks using
the new methodology. My data set consisted
of all the U.S. stocks that received the old
rating from August 2009 to August 2019 and the
new ESG Risk Rating since September 2019.
I then collected monthly returns, market
capitalizations, and price/book ratios from
Morningstar Direct for all the stocks that received
ESG ratings. I excluded stocks with an initial
price of less than $2 and market caps of less than
$100 million in each month to avoid low-price
stocks and micro-cap effects. After all screenings,
there were 415 stocks in August 2009, 2,044 in
June 2016, and 2,726 in November 2020.
Characteristics of the ESG Risk Rating
One of the main features of the ESG Risk Rating
is that it makes it easy for investors to make
comparisons across industries and sectors. The
lower the score, the less exposure the company
has to ESG risks and the better it is at managing
the risks it does face. The average ESG Risk
Ratings for stocks categorized by the 11 sectors
using the Global Industry Classification Standard
are shown in EXHIBIT 1 . Note that the sectors
with the highest average ratings are generally
viewed as the less sustainable areas of the
economy. It is not surprising that oil companies in
the energy sector would have severe unmanaged
ESG risks. Likewise, the lowest scores are in
sectors traditionally viewed as more sustainable.

https://jesg.pm-research.com/ https://jesg.pm-research.com/ https://direct.morningstar.com/cloud/ https://www.sustainalytics.com/esg-data https://www.sustainalytics.com/esg-data https://www.sustainalytics.com/esg-data https://www.sustainalytics.com/esg-data

Morningstar - Q4 2021

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