Financial regulators in the US and overseas along with other stakeholders have more recently been stepping up their attention to environmental, social, and governance (ESG) ratings, highlighting the challenges and potential conflicts of interest involved in ESG rating and scoring systems. 

Although ESG ratings are frequently used by asset management firms to construct sustainable portfolios and carry out their sustainable investing mandates, ESG ratings are still ill-defined and rely on incomplete publicly available historical data.  According to European Securities Markets Authority (ESMA), these result in the risks of capital misallocation, product misselling, and greenwashing are high while, at present, there are no appropriate legal tools to address these issues. 

In the light of the challenges involving ESG rating and scoring systems and debates that are expected to continue for some time, investors allocating funds to active and passively managed mutual funds and ETFs need to take a more active due diligence role to understand the sustainable strategies pursued by their portfolio of funds.  Sustainable Research and Analysis is recommending the following three-step process for current and future sustainable investors.

Active Investment StrategyIndex Tracking Strategy
1. Revisit fund choice(s) to understand the investment manager’s sustainable investing process. 1. Revisit fund choice(s) and review the construct of the tracking index, ESG data provider, and ESG rating methodology.  In this connection, understand how factors are weighted when determining an aggregate rating and why? 
2. Seek to understand the investment manager’s consideration of factors that support the sustainable investing approach.  To the extent external ESG ratings are used, seek to understand the ESG rating methodology and how such ratings might influence investment decision making and security selections or exclusions.2. Review and seek to understand the screening rules governing the tracking index, including positive and negative screening criteria.  Understand which positive and negative factors are chosen, how they are measured, and why.
3. Confirm that the manager’s sustainable investing process results in a portfolio that continues to align with your sustainability preferences.  3. Confirm that the manager’s sustainable investing process results in a portfolio that continues to align with your sustainability preferences.  

Source:  Sustainable Research and Analysis LLC

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