Fund buyers get more discerning with ESG picks

In December, Last Word Research commented on the rise in popularity of ESG investing and the impact Greta Thunberg is having on the financial industry. This month, we look at the relationship between funds rated by Morningstar as ‘high’ for their ESG credentials, and those expected to have the best future performance among their peers. Funds that sit at the top of this forward-looking ranking are awarded ‘gold’.

The table below shows all UK-domiciled funds ranked gold under this system. It is clear that, despite the expectation these funds will outperform their benchmarks in the upcoming months, few are also rated ‘high’ in the Morningstar sustainability tables, with the majority labelled as ‘average’.

Source: Morningstar

Aiming high

Why does this matter? Investors may want to focus on a fund’s performance rather than its ESG compatibility. If this is the case, you would think they would rely just on the Morningstar analyst rating to select their next fund.

However, a recent Last Word Research study shows funds that complied with ESG challenges, and had a Morningstar sustainability rating of ‘high’, significantly outpaced those marked as ‘low’ or ‘below average’ for net fund flows, and therefore sales.

The figure below shows net flows for all UK-domiciled funds with a Morningstar sustainability rating. In every month there were net inflows into funds ranked ‘high’, which from January to December totalled £23bn. For funds marked ‘low’ there were net outflows of £15bn during the same time period.

To paint a clearer picture, figure 2 below shows net flows for all UK equity funds in 2019, which includes those with and without Morningstar sustainability ratings. As you can see, it has been a tough year for the asset class, with a whopping £57bn net outflows between January and October 2019.

Marked down

If net flows for funds within this asset class are divided up by their Morningstar sustainability ratings, as in figure 3 above, those ranked ‘high’ fared much better than their lower-ranked peers when it came to net flows.

Even during the period of significant outflows from UK equities (January-October 2019), there were net inflows totalling £10bn into funds Morningstar ranked ‘high’.

Every quarter, Last Word Research produces an asset allocation report that provides a snapshot of the forward-looking investment sentiments of some of the biggest UK fund selectors.

The last round of data was collected in November and December 2019, and it was clear that appetite for buying UK equities has not just reversed course but increased substantially. Despite this, funds with a Morningstar sustainability rating of ‘below average’ or ‘low’ by were hit by further net outflows during this time.

During the past year, a trend has emerged in which funds deemed highly ESG-compliant are in aggregate beating their lower-ranked peers when it comes to net flows.

Going for gold

Why does Morningstar fail to take this into account when compiling its Morningstar analyst ratings? The table below shows all UK-domiciled funds that received a ‘high’ sustainability ranking, yet only five of these also have a ‘gold’ analyst rating.

Though strict compliance to ESG criteria does not guarantee improved future performance, or beating the benchmark, appetite for investing in ESG funds is clearly increasing, and more money has flown into funds that are highly ESG compliant.

When it comes to its analyst ratings, Morningstar may need to start considering ESG compliance or, at the very least, attach greater importance to such factors.

Source: Morningstar

This article was written by Lottie McGurk, a quantitative researcher at Last Word Research

If you wish to see the full results of our research, or discuss any of this further, please contact lottie.mcgurk@lastwordmedia.com