ESG ratings: Look closer

Key takeaways

  • Sustainable investing has attracted many investors.
  • ESG ratings providers may help you find investments with favorable sustainability scores.
  • But ESG ratings and methodologies are not all the same.

The first global index to track sustainability-driven public companies was the Dow Jones Sustainability Index (DJSI) in 1999. Investing using the principles of sustainability—which is now done via environmental, social, and corporate governance (ESG) factors—is not new, but it has changed over time, and has exploded in popularity in recent years.

If you are an individual investor looking for sustainable investing choices, ESG ratings may help you better sort through potential opportunities. But ESG ratings are not all the same due to the differences in factors considered, how they are interpreted and expressed, and how these approaches differ among providers. Here's what investors should consider when evaluating ESG ratings.

How can ESG ratings help you?

Similar to how knowing a mutual fund or ETF's exposures to market cap, sector/industry, style, and other characteristics can help you make better investing decisions, you can benefit from knowing how a potential investment scores when it comes to sustainability and ESG factors—if these factors are important to you. Companies vary dramatically in the ways they focus on sustainability risks and opportunities across their businesses, and individual investors may not have the experience or expertise needed to evaluate how those risks and opportunities might affect a potential investment.

That's where ratings can help. Consider a hypothetical scenario where you want to look for sustainable investing funds and you decide to run a screen on by selecting the "Sustainable Attributes" filter within the mutual fund evaluator. While the funds in this screen may qualify as sustainable investments based on ESG characteristics, to some extent, there may be different underlying characteristics about each fund that drive this classification. For example, a fund in this screen that qualifies based on renewable energy characteristics may include companies where only a small part of their overall operations is involved in green energy production. If the rest of those company's operations aren't environmentally focused, it may not meet your criteria for investing based on this ESG factor.

ESG reports and ratings may help you make these types of assessments. ESG ratings from providers can provide a qualitative assessment of how well a fund and its constituents align with ESG factors. With that said, a provider's ratings methodology may not be fully disclosed to investors, making transparency a potential issue.

ESG ratings up close

If ESG factors are important to you, an ESG ratings system that ranks opportunities along a spectrum according to how closely a company or components of a fund follow best ESG practices can help differentiate between investments with ESG practices that align with your sustainable investing goals and those that do not. Ideally, an ESG ratings system identifies the key factors that go into evaluating sustainability practices. Carbon and toxic emissions may carry more weight relative to other factors for an energy company's environmental rating, for instance, whereas product safety and drug pricing can be the critical factors for a health care company.

Understanding the methodology and ESG factors utilized by a ratings provider is important. It can also be helpful if the output results in an easy-to-understand ratings system. Providers that offer ESG ratings will have differing recommendations and opinions, where ratings methodology, scope, and coverage can and will diverge from one another.

Many ESG data providers focus on information disclosed by companies and historical data points, rather than anticipating the future trajectory of a company's sustainability efforts. While this information is useful for assessing where an investment stands today, it can fail to assess where it may be heading in the future—as it relates to ESG factors. It is Fidelity's view that a forward-looking, fundamental analysis can provide a better assessment of how a company is considering sustainability risks and opportunities within its business model.

A forward-looking analysis can be especially helpful for assessing smaller companies that lack the resources to reach the disclosure transparency of larger peers. It can also help identify companies that may not currently appear attractive from a sustainability perspective, but are making changes that demonstrate improvement and positive momentum, or vice versa.

The bottom line on ESG ratings

If you like using ratings from research providers to evaluate investments, ESG ratings can be another valuable tool. Ratings that differentiate which funds are composed of companies who are focused on managing their sustainability risks and opportunities, for instance, and those that are laggards, may help you find investments that align with your objectives.

Of course, even when utilizing ESG ratings, you should dig deeper into the investments that you are considering. Simply because an ETF or mutual fund scores well on a provider's ESG ratings scale doesn't necessarily mean it meets your preferred sustainability or ESG characteristics or that it makes sense for your investment mix. With that said, ESG ratings can be a useful tool to help you find investments that align with your sustainable investing objectives.

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More to explore

ESG-focused ETFs

Search for ETFs with strategies that may meet your sustainable investing goals, such as strong employee relations, efficient use of natural resources, or gender diversity.

ESG-focused stocks

Search for stocks based on MCSI ESG criteria, such as accounting and governance risk score, environmental score, social score, governance score, or overall ESG rating.

Investing based on environmental, social and corporate governance (ESG) factors may cause a strategy to forgo certain investment opportunities available to strategies that do not use such criteria. Because of the subjective nature of sustainable investing, there can be no guarantee that ESG criteria used by Fidelity will reflect the beliefs or values of any particular client.

Investing involves risk, including risk of loss. All indexes are unmanaged, and performance of the indexes includes reinvestment of dividends and interest income, unless otherwise noted. Indexes are not illustrative of any particular investment, and it is not possible to invest directly in an index. Stock markets are volatile and can fluctuate significantly in response to company, industry, political, regulatory, market, or economic developments. Investing in stock involves risks, including the loss of principal.

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