Morningstar's sustainability ratings cover 178 ETFs

Energy and gold funds among top-rated in category-based system.

Rudy Luukko 14 March, 2016 | 5:00PM
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The Canadian universe of exchange-traded funds is nearly virgin territory for investment managers that define themselves as being socially responsible. Of the 178 Canadian-listed ETFs that have received a Morningstar Sustainability Rating, only one -- the $28-million iShares Jantzi Social Index (XEN) -- has an explicit mandate to screen for environmental, social and governance (ESG) factors.

The selection is much wider in the universe of Canadian mutual funds, even if explicit socially responsible mandates represent only a tiny portion of total assets under management. More than a half a dozen mutual-fund companies offer one or more funds that conduct formal ESG screening.

But as previously announced, there's a new method from Morningstar to assess the degree to which the holdings of managed funds are consistent with good ESG practices. The Morningstar Sustainability Rating system is applied to the broad universe of managed funds, not only those that are marketed as being socially responsible investments.

The rating system is based on company research carried out by Sustainalytics -- the same firm that conducts the ESG screening for iShares Jantzi Social Index. So it's not surprising that this ETF received the top Morningstar Sustainability Rating of high, as depicted by five globes.

Among specialty equity ETFs, iShares Global Water Index (CWW) -- investing in water-related utilities, infrastructure and equipment -- would seem to be the type of investment mandate that would score highly on ESG criteria. And it did, also receiving a five-globe Morningstar Sustainability Rating.

While water industries seem like a natural fit for top sustainability ratings, what some investors might at first find surprising is that a fund could also achieve the top rating with a portfolio consisting of oil and gas companies or junior gold miners. Canada's group of 31 top-rated ETFs includes iShares S&P/TSX Capped Energy Index (XEG), BMO S&P/TSX Equal Weight Oil & Gas Index (ZEO) and BMO Junior Gold Index (ZJG), all of which invest in industries that have significant environmental impacts.

The explanation for the seemingly odd bedfellows among top-rated ETFs is that the Morningstar Sustainability Rating is based on comparisons within fund categories. It's the same principle that applies when giving a fund or ETF a Morningstar Rating of one to five stars for risk-adjusted performance. Funds are compared to their category peers, not to the fund universe as a whole.

Because Morningstar's ratings are based on fund categories, passively managed ETFs that employ traditional market-capitalization-weighted indexes are likely to have average sustainability ratings. That's where you'll find ETFs such as iShares Core S&P/TSX Capped Composite Index (XIC) and BMO S&P 500 Index (ZSP). However, Canada's largest ETF -- the $10.3-billion iShares S&P/TSX 60 Index (XIU) which is a market-cap-weighted portfolio of 60 of Canada's largest and most liquid stocks -- is rated above average with a four-globe rating.

No single ETF company in Canada dominates the top ratings for sustainability. BMO ETF, with seven, has the most five-globe-rated ETFs. That's one more than the iShares and Horizons families, with six apiece, followed by First Asset with five.

Among the top-rated ETFs for sustainability, another pattern that seems to emerge is that there are numerous dividend or equity-income mandates. A dozen industry-diversified ETFs with five-globe ratings are variations on this theme. Some examples are iShares Canadian Select Dividend Index (XDV), PowerShares Canadian Dividend (PDC) and RBC Quant EAFE Dividend Leaders (RID).

These and other sustainability ratings are subject to change, normally monthly, when Morningstar receives updated portfolio holdings. The ratings for mutual funds and ETFs were initially published on Morningstar Direct, the online research platform for institutional and advisor markets.

Starting on March 17, the ratings will be published on Morningstar.ca, and they'll also appear on various Morningstar websites around the world. The ratings on Morningstar.ca will be a new addition to the online fund reports that you can find online via the Fund Lookup tool.

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About Author

Rudy Luukko

Rudy Luukko  Rudy Luukko is a freelance writer who contributes to Morningstar.ca on topics involving fund industry trends and regulatory issues. He retired in May 2018 from his position as editor, investment and personal finance, at Morningstar Canada, where he had worked since 2004. He has also worked as an editor and writer for various general, specialty and institutional media, and he has co-authored courses for the Canadian Securities Institute. Follow Rudy on Twitter: @RudyLuukko.

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