Admittedly, the title here is way too optimistic.
ESG is nuanced and complex. It is too often conflated with sustainability, so much so that the ESG rating agencies and their data often get pulled into the debate. Last week, a report in the Financial Times declared Hundreds of funds to be stripped of ESG rating. Based on a leaked BlackRock memo about potential changes to MSCI’s rating coverage, the rumored actions could shift the landscape around what is considered an ESG investment fund and what isn’t.
I’m surprised this news hasn’t reached and been malformed into the anti-ESG narrative yet. I suspect there is an anti-ESG analyst out there trying to spin it one way or the other. Still, a few people, mostly financial services experts, are discussing it, and I thought I’d wade in on what is happening and where it could be going.
What does MSCI do anyway?
Let’s start with the basics. MSCI is one of the world’s leading ESG data aggregators and research firms. They provide data, analysis, indices, and more to financial services firms worldwide. In its About Us brochure, MSCI puts it as “informing the world’s leading investment decision-makers.”
MSCI has many products and offerings, but its ESG ratings of public companies tend to be the focus of the work called out. For example, if you visit MSCI’s ESG Ratings & Climate Search Tool, you can search for public companies and uncover information about MSCI’s sustainability and ESG perspectives for that company.
This FT story is focused on changes MSCI is making around its fund ratings. MSCI will rate the fund with its publicly available ESG Fund Ratings. It’s worth noting that additional ESG rating data is available if you subscribe to their data feeds.
Here is my take on what’s on the page:
Implied Temperate Rise - Showcases the impact of the fund on the global temperate rise. Useful for activist investors to determine if the fund is on a path aligned with its values.
Climate Transition Risks - This considers the carbon characteristics of an index or portfolio. For example, it shows the Weighted average carbon intensity, tCO2e/$M of sales.
ESG ratings - These run similar to credit ratings. Per the site, “Our ESG Ratings provide a window into one facet of risk to financial performance.” For me, risk is the keyword, so these are, in fact, ESG ratings. Unlike the stock ESG ratings, material risks are not included here, and I suspect it is because material issues range too far across a fund’s holdings.
Board Independence and Diversity - An independent board member is someone without a material connection to the business. Board diversity here refers to women on the board.
Business Involvement Screens - This section is for values or thematic investing. For example, if the investor wants to avoid controversial items completely.
Part of the criticism of these scores (and those from any ESG data provider) is that they can be a black box backed by incredible research and much nuance. I find the scores useful as a guidepost, but always do my own due diligence to supplement this information. Conducting due diligence on stocks can be pretty straightforward, but it can be an intense personal challenge for a fund.
What is happening?
And so, let’s get back to the Financial Times article. At a high level, MSCI appears to be changing how it rates ‘synthetic’ or swap-based ETFs. These ETFs are ones that do not hold the stocks on an index but invest in a derivative. As a result, the investor receives returns but not other benefits like dividends or proxy voting rights.
In my opinion, this may be the core issue at stake here. Since you don't hold the stock if you invest in a swap-based investment product, can you claim that it is a sustainable or ESG fund?
Keep in mind that in the EU, funds and their ESG and/or sustainability language are regulated by SFDR. This regulation has three articles that cover this language, specifically in Articles 6, 8, and 9.
Article 6: Default classification. If ESG risks are considered, they must be described.
Article 8: More thematic, describing how sustainability, governance, and other ESG and non-ESG factors might be used.
Article 9: More Socially Responsible or Impact Investing based, with the objective of the product having an environmental or social impact.
But…these requirements only apply if you have created an ETF that holds stocks, not the swap. Per ETF Stream,
Currently, SFDR disclosure requirements for swap-based ETFs are fulfilled at the underlying index level, meaning there are no SFDR requirements for the substitute basket (read swap here) used to replicate the index.
So it looks like removing the ESG ratings for these funds would make sense as it would align closer to the regulatory labeling perspective of the EU.
Another aspect of this, which is a little less clear in the article, is that MSCI will potentially lower its ratings for ETFs with stock holdings. Per the FT, MSCI believes this:
will lead to fewer funds being rated as AAA or AA and will reduce the volatility in ESG fund ratings, which are outcomes that our client base broadly supported.
The reason isn’t clear, but clarity itself may be the reason. Volitility represents uncertainty and risk, so this change may align fund ratings closer to their actual impacts and risks. It’s hard to say at this point until we learn more. What would be interesting would be an entirely new scoring mechanism overall that considers the different investment theses out there. For example, this fund is trying to do this action and we believe it will or this fund is has integrated ESG risk well, we are rating it high. We’ll have to wait and see what the explanation and results are.
What’s Next?
It’s difficult to determine what might happen as a result. This could impact the derivative markets as sustainable or ESG investors may not choose these products without the rating. Fund managers with actual stocks may also scramble to reallocate capital in their funds to attempt to bring their scores up, driving a consolidation towards companies with higher ESG ratings. Could broader money movement be coming as a result of this first move? Per the FT article (and widely reported elsewhere), “65 per cent of inflows into European ETFs, according to Morningstar.” It’s impossible to tell at this point.
Effectively, what we appear to know are these things will happen:
MSCI will remove swap-based ESG ratings, allowing the underlying stock and funds with stocks to remain rated but not the derivatives. As a result, regulators may back off a bit.
The number of ESG-rated swap-based funds drops significantly as a result.
The number of AAA funds with stocks goes down.
This is a good reminder to financial services firms that their products must continue to be labeled accordingly under SFDR, which is intended to bring clarity to investors. I’ve been writing about this all along:
Financial Services firms must clearly articulate their products’ ESG and/or sustainability, social, and governance information to investors.
Clear communication to investors is critical. What’s still unfortunate is that it is difficult to tell which funds have conflated ESG and sustainability. MSCI’s move, and if other rating agencies make similar adjustments, could push financial services firms to gain that clarity, directly or indirectly through new approaches. The reality may be that little changes though. After all, these funds tend to have higher fees, and if you aren’t paying for that analysis and clarity (and I’d say engagement with the investment), what are you paying for anyway?
As always, for retail investors, I encourage you to use these scores like I do, as a guidepost, and conduct your own due diligence.
For financial services firms, the recommendation here is to be ready if investments are redirected away from swap-based funds as a result of this move. In other words, this could be a risk for some and might create an opportunity for a firm with clear communication with investors.