Morningstar - Q3 2022 - 11

EXHIBIT 7
EXHIBIT 8
Quantitative Rating Average Annual
Excess Return vs. Category Average
Œ
„
Œ
„
Œ
„
´
‰ Á
´
‰ Á
´
‰ Á
Average
Excess Return
AverageAverage
Excess Return
Excess Return
1.5%1.5%
1.5%
1.0
0.5
1 Year 1 Year
1 Year
3 Year 3 Year
3 Year
5 Year 5 Year
5 Year
Source: Morningstar Direct. Data as of 02/28/2022.
1.01.0
0.50.5
0 0
-0.5-0.5
-0.5
1 Year 1 Year
1 Year
3 Year 3 Year
3 Year
5 Year
Source: Morningstar Direct. Data as of 02/28/2022.
-1.5 -1.5
-2.0-2.0
5 Year 5 Year
-1.5
-2.0
1 Year 1 Year
1 Year
3 Year 3 Year
3 Year
5 Year 5 Year
5 Year
Source: Morningstar Direct. Data as of 02/28/2022.
0 0
Average Annual Excess Return vs.
Category Index
Œ
„
Œ
„
Œ
„
´
‰ Á
´
‰ Á
´
‰ Á
Average
Excess Return
AverageAverage
Excess Return
1.0%
0.5
Excess Return
1.0%
0.5
-0.5-0.5
-1.0 -1.0
1.0%
0.5
-0.5
-1.0
20
20 20
EXHIBIT 9
Success Rates vs. Category Index
Œ
„
Œ
„
Œ
„
´
‰ Á
´
‰ Á
´
‰ Á
Percentage of Funds
Exceeding Category
Index Return
60
Percentage of Funds
Exceeding Category
Index Return
Percentage of Funds
Exceeding Category
Index Return
60 60
40
40 40
performance penalty, as performance was similar
across the ratings range.
This picture changes when we limit the universe
to " intentional " ESG funds. Intentional funds,
unlike nonintentional, clearly prioritize ESG
investing, typically by putting ESG in the fund's
name and making it a central part of the strategy's
mandate. When we evaluated the performance
of the ratings assigned to intentional funds,
we found that they've sorted future performance
pretty well since inception, if less so recently.
We also examined how well U.S. stock funds'
ESG risk scores sorted future performance.
To review, a fund's Sustainability Rating is based
on how its ESG risk score compares with that
of others in its global category. The lower a fund's
ESG risk score versus its category peers, the
higher the rating. But to those investors seeking
to minimize ESG risk in absolute terms, the
ESG risk score is more relevant.
Given that, we grouped U.S. stock funds by their
ESG risk scores from least risky to riskiest
and then averaged the trailing returns of the
funds in each cohort. We found that U.S. stock
funds with less ESG risk have slightly
outperformed riskier funds since the rating's
2019 inception.
Opportunities for Improvement
These findings are broadly encouraging, but we
have some opportunities for improvement:
gThe star rating doesn't " corner " well.
While the star rating has been effective in sorting
funds based on future performance over the
long haul, it has struggled lately, with lower-rated
funds outperforming higher-rated funds. The
star rating tends to sort the best when markets are
trending higher but has been prone to falter
amid transitions, when market leadership changes.
This is a limitation of a rating system that's
based entirely on past performance and explains
why we consider the star rating a starting point for
research, not an all-in selection tool.
gMedalists haven't beaten their benchmarks.
The forward-looking Analyst Rating
and Quantitative Rating have generally been
successful sorting funds based on future
performance versus a category average, with
higher-rated funds succeeding more often
than lower-rated funds, on average. Nevertheless,
Gold-, Silver-, and Bronze-rated funds have
not outperformed their benchmark indexes, on
average. This leaves room for improvement,
as these ratings systems aspire not just to sort
well based on future performance, but to
reserve the highest ratings for active funds that
beat their market indexes over a full cycle.
So far, they haven't met that mark.
gThere is confusion regarding ESG and performance.
While it's true that the Sustainability Rating
doesn't purport to predict how funds will perform,
there has been considerable debate about
the relationship between material unmanaged ESG
risk (which the rating denotes) and future
returns. Some believe that minimizing this risk can
lead to superior returns. But the data-albeit
limited to the Sustainability Rating's brief life-
is mixed. This is encouraging insofar as it indicates
that committed ESG investors aren't incurring
a big performance penalty. But it also raises
questions about whether minimizing ESG risk will
pay off in the form of above-average returns. K
Jeffrey Ptak, CFA, is chief ratings officer at Morningstar
Research Services LLC. He is a member of the editorial
board of Morningstar magazine.
morningstar.com/products/magazine
11
https://www.morningstar.com/authors/489/jeffrey-ptak http://www.morningstar.com/products/magazine
Morningstar - Q3 2022

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