Morningstar - Q1 2020 - 37

of sector indexes. In E X H IBI T 2 , we plot the scores
for each of the Morningstar sector indexes.
Unsurprisingly, energy, utilities, and basic
materials have the highest ESG risk profiles, with
scores of 38.9, 33.2, and 28.4, respectively.
Real estate and technology are the sectors with
the lowest ESG risk, with scores of 17.4 and
20.4, respectively.
For well-diversified portfolios, we expect scores
to change based on a portfolio's sector allocation.
A fund overweight to energy or utilities will
have a worse Portfolio Sustainability Score
because companies in these industries tend to
have high amounts of unmanaged risk.
Similarly, a fund with overweight exposure to
technology or real estate will have a better
sustainability score, because such areas typically
have low unmanaged risk.
Tackling Funds With High and Severe ESG Risk
The Morningstar Sustainability Rating
methodology will now feature special handling for
portfolios classified with High or Severe ESG
risk. Because the distribution rules are applied
within global categories, portfolios with High
or Severe ESG risk could still receive better-thanaverage sustainability ratings (for example,
portfolios in the energy category). Therefore,
as a final ratings check, we impose requirements
depending on a portfolio's level of ESG risk,
regardless of how well they rank within their
global Morningstar Category:

gPortfolios that have a Historical Portfolio
Sustainability Score from 30 to 34.99 can receive
no better than a sustainability rating of 3 globes.
gPortfolios with a sustainability score from 35 to
39.99 can receive no better than 2 globes.
gPortfolios with a sustainability score of 40 or higher
receive a 1 globe.
Let's take a few examples.
The Invesco Dynamic Oil & Gas Services ETF PXJ
has a Historical Portfolio Sustainability
Score of 33.3, placing it in the High ESG risk range.
Within the global fund equity energy category,
the fund's percentile rank is 22, so its sustainability
rating would be 4 globes. Because the fund's

ESG PERSPECTIVE

Identifying Opportunities Through an ESG Analysis
Masja Zandbergen helps the investment teams
at Robeco, an international asset manager
based in the Netherlands, incorporate ESG into
their investment process. She helped establish
Active Ownership, the firm's proxy and corporate
engagement approach, in 2003. She says
that Robeco and sister firm RobecoSAM, which
focuses on sustainable investing, view
ESG-related risks from a valuation perspective.
Morningstar: Why does Robeco integrate ESG into
all its investment processes?
Masja Zandbergen is head
of sustainability integration
at Robeco.

Zandbergen: We believe it contributes to
society and makes us better investors. It forces
us to add an even more long-term view
and also to look at information other fund
managers do not see as relevant, or do not have
enough experience with to make good
use of. Our investment teams can draw upon
the longstanding expertise of our sustainable
investing research team at RobecoSAM
and the Active Ownership team at Robeco.
I want to make clear that ESG integration
does not necessarily lead to avoiding
"bad" companies straight away. It leads to "bad"
companies becoming less attractive from
a valuation perspective. And we apply this for
all the strategies that we manage-not
only sustainable strategies. One consequence
is the multiplication of brainpower. Our
quantitative researchers have come up with
a way to decarbonize the value factor, and our
fundamental analysts are working on
climate scenarios to better analyze the impact
on energy companies.
How does ESG analysis help investors assess risk?

We do not believe it only helps to assess risks.
It also helps to identify opportunities. In an

investment strategy that focuses on companies
with increasing free cash flows and high
ROIC, such as our fundamental global equity
strategy, our ESG analysis on average actually
increases our target prices. If we find interesting
companies and they have good management
of material ESG issues, it raises our conviction.
In value-based approaches, such as our
fundamental Asia-Pacific and emerging-markets
strategies, and in credit strategies, the
focus is indeed on identifying risks. Credit
investors are really penalized when companies
cannot repay loans. In emerging-markets
and value strategies, the trick is to avoid the
value traps. We have many examples
where bad corporate governance prevented us
from investing and that turned out to help
us tremendously.
Are there sectors where ESG risk analysis is
particularly vital?

ESG risks are most vital in carbon-intensive
industries and industries with high risk
on human rights violations and accidents, such
as energy, utilities, car manufacturers,
mining companies, etc.
Outside of governance and climate change, what are
some less well-known ESG risks?

When we look across asset classes and sectors,
we find that corporate governance is by
far the most important topic, and climate and
eco-efficiency comes second. Social issues, when
added up, are also very relevant, but there
are many different categories. We find human
capital management, including innovation
management; supply-chain management; and
license to operate-how companies are operating
within their communities-to be important.
Some topics that were added as new
engagement themes in 2019 for our Active
Ownership team were social issues
around artificial intelligence, digital healthcare,
single-use plastics, corporate governance in
emerging markets, and biodiversity.

Morningstar - Q1 2020

Table of Contents for the Digital Edition of Morningstar - Q1 2020