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How Sustainable are European Equity Funds?

January 19, 2017

It is commonly believed that sustainable investing is only about those who opt for investments that reflect their values. But times are changing; large numbers of asset managers are incorporating environmental, social and governance considerations into their investment processes. And this is not statement on values, it is because they find ESG evaluations can lead to more sustainable financial returns.

In a similar way, we believe investors should also be better informed on the ESG disciplines of the funds they are considering to buy, or indeed already own. Just over six months ago we launched the industry’s first sustainability rating for funds and ETFs, the Morningstar Sustainability Rating. The key purpose of the rating is to give investors a fresh perspective on how well the underlying companies in a fund are doing on sustainability relative to their peers.

What is the Morningstar Sustainability Rating?

The Morningstar Sustainability Rating is based on ESG company research from Sustainalytics, a leading provider of ESG and corporate governance ratings and research. To derive the rating, we first calculate a Portfolio Sustainability Score, which is based on a portfolio’s ESG score and a deduction for current ESG-related controversies. Sustainalytics classifies controversial events involving companies by severity across five categories, with category 5 being the most severe. To arrive at the rating, we then sort funds into five normally distributed groups by comparing a fund’s Portfolio Sustainability Score with that of its Morningstar category peers.

Amongst the top-10 largest active European equity funds within the Morningstar Europe Large-Cap Blend Equity Category, the results are mixed. Five out of the ten funds have favourable ESG scores relative to their category peers, but the incidence of controversies amongst the funds overall has been high and has dragged their overall Morningstar Sustainability Ratings down.

A Morningstar Sustainability Rating of High, or 5 Globes, indicates that the companies held in a fund’s portfolio are better at managing their ESG risks and opportunities than those held in at least 90% of portfolios in the same Morningstar Category. None of those prominent funds earned a 5-Globe rating.

Henderson Fund Scores Highly

The only fund on this list with an Above Average rating, which is equivalent to 4 Globes, is the Henderson Horizon Pan European Equities fund, run by Tim Stevenson and which has long-held a Morningstar Analyst Rating of Silver. We’re not surprised that the companies in this fund, on aggregate, score well on ESG and have limited controversial involvement. This outcome is a function of the manager’s focus on identifying high quality companies with a strong long-term growth potential, wedded to a well-founded responsible investment philosophy at Henderson.

Indeed, it is worth noting that on average across its fund range, the sustainability ratings of Henderson Global Investors – a signatory of the UN Principles for Responsible Investments–have been slightly above average. That’s not to say that the fund has zero exposure to companies with controversies, but it has avoided some of the more widely held stocks with poor controversy scores, such as Royal Dutch Shell (RDSB), Bayer (BAYN) and Sanofi (SAN). The fund has also had no exposure to tobacco stocks over the last ten years.

Funds Causing Controversy

Whilst Fidelity European Growth and Invesco Pan European Equity both have Above Average ESG scores relative to their peers, their controversy scores rank amongst the worst in the category and have dragged their overall Sustainability Rating down to Average and Below Average, respectively. The Fidelity fund has had an overweight in the energy sector, where the incidence of controversies is higher, and has held Royal Dutch Shell, which has a category 4 controversy score.

According to Sustainalytics, the company’s operations are linked to severe environmental pollution; during the past five years, the company has spilled 12.6 thousand tonnes of oil worldwide. A number of stocks with a category 3 controversy score feature in the Invesco Pan European Equity fund, including Intesa (ISP) and Lloyds (LLOY), and two stocks with a category 4, namely Royal Dutch Shell and Novartis (NOVN).

According to Sustainalytics, in 2016 the US government requested that Novartis provide documents of 80,000 events in the period 2002 to 2011 at which doctors allegedly received kickbacks for prescribing the company’s drugs. In addition to this investigation, the company has faced investigations related to bribery in seven markets in recent years.

Funds with Unsustainable Practises

At the other end of the spectrum is BGF European Focus, which has a 1- Globe Morningstar Sustainability Rating. Royal Dutch Shell has been a top holding in this focused portfolio of around 40 stocks and this would have impacted this portfolio to a greater extent than comparable peers holding a smaller position in the stock, given that the rating is asset-weighted. In addition, the fund has also held the two tobacco stocks, British American Tobacco (BATS) and Imperial Brands (IMB), as well as Lloyds Banking Group, which has been involved in multiple lawsuits with respect to its products and customer services.

The two tobacco companies both have a history of controversies involving human rights abuses in their supply chain. According to Sustainalytics, in May 2016, the NGO Human Rights Watch published a report detailing its field research into the Indonesian tobacco farming industry, which found widespread child labour for tobacco leaf cultivation and curing.

From a performance standpoint, the majority of those prominent European equity funds have generated returns that beat most of their category peers as well as the broad market index over the last decade. Having said that, the Morningstar Sustainability Rating is a portfolio-based rating that measures how well the companies held in a fund’s current portfolio are managing their environmental, social, and governance, or ESG, risks and opportunities relative to their industry peers. We don’t know and we can’t say whether these funds would have had better sustainability ratings over the past decade.

Source: Morningstar. Muna Abu-Habsa | 19/01/2017