ESG ratings: Look closer

Key takeaways

• ESG investing has exploded in popularity.
• ESG ratings can help you find investments that align with your principles.
• 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 to more closely align your principles with your investments by incorporating an ESG approach, 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 aligns with ESG principles—if these factors are important to you. Companies vary dramatically when it comes to how they align with ESG factors, and individual investors may not have the experience or expertise needed to evaluate how well an individual investment or an ESG-focused fund aligns with their principles. 

That's where ratings can help. Consider a hypothetical scenario where you want to look for sustainable-investing-focused funds and you decide to run a screen on Fidelity.com by selecting the "Socially responsible" theme within the ETF Screener (login required). While the funds in this screen may qualify as sustainable investments based on ESG characteristics, to some extent, they may not align with your specific principles. 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 goals and those that do not. Ideally, an ESG ratings system identifies the key factors that go into evaluating ESG 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 (see Fidelity's ESG ratings system sidebar as an example). 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 incorporating a more robust ESG implementation into 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 actually committed to improving their ESG characteristics, for instance, and those that are pretenders or 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 ratings scale for adhering to ESG principles, that doesn't necessarily mean it meets your preferred 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 principles and objectives.