Thousands of funds get ESG downgrades

After raising the bar on its ESG ratings, tens of thousands of funds are facing a downgrade from MSCI Inc.

The index firm said that changes to its ESG ratings methodology, which are intended to raise the requirements for funds to earn a AAA or AA rating, is shifting the distribution its ratings, resulting in downgrades for approximately 31,000 funds when the changes take effect in April.

In a report detailing the shift, MSCI said that the changes to its methodology were “driven by consultations with clients, based on market feedback and are not, as has been reported, linked to regulatory developments in the EU or elsewhere.”

The report noted that the consultation, which was carried out last year, came in response to clients’ concerns about an “upward drift” in ratings among its universe of funds.

Following the consultation, the firm has decided to do away with adjustments to the ESG quality scores that underpin its ESG fund ratings.

Previously, MSCI adjusted funds’ ESG scores to reflect their exposure to companies with improving ESG performance.

Yet many companies enjoyed improving scores, it said, noting that every sector improved its ESG performance in the year ended Feb. 28 — as a result, the majority of funds also enjoyed upward adjustments to their ESG ratings.

“In this new era where improvement in ESG is the status quo, we believe that the threshold required to receive a top ‘AA’ or ‘AAA’ rating should be more rigorous and ambitious,” the firm said.

As a result, MSCI is doing away with those adjustments, which will result in a one-time change to funds’ ratings, and isn’t indicative of future downgrades, it said.

“In effect, the goal posts are shifting, rather than any funds becoming worse as a result of their current allocations,” it said, as funds’ ESG scores will now reflect a simple weighted average of the ESG scores of the underlying holdings.

“The MSCI ESG fund rating will purely be a reflection of the holdings’ aggregate resilience to ESG risks and opportunities,” it said.

Eliminating the adjustment factor and simply basing funds’ ratings more directly on the ratings of their portfolio holdings will also improve the stability of MSCI’s ESG ratings, and boost transparency, it noted.

“Assessments of funds’ ESG characteristics can be an important input to the fund selection process, but to be useful for decision-making, assessments need to provide meaningful differentiation and a meaningful reflection of funds’ ESG exposures,” the report noted.

Additionally, MSCI is also expanding its coverage of fixed-income funds, adding about 8,200 bond funds to its coverage universe, thanks to another methodology change. Previously, it required that 65% of a funds’ assets has to have an ESG rating to qualify for the fund to receive a rating. It’s now lowering that threshold to 50%, in an effort to “address a structural bias driven by fixed income security types, such as asset-backed or mortgage-based securities that are currently out of scope for ESG analysis.”

James Langton

James is a senior reporter for Advisor.ca and its sister publication, Investment Executive. He has been reporting on regulation, securities law, industry news and more since 1994.