Combining ESG Risk and Economic Moat

Enhancing the Risk-Return Profile of Equity Portfolios

Executive Summary
10 December 2020 In this report, we showcase the possible synergistic applications of
Sustainalytics’ ESG Risk Ratings and Morningstar's Economic Moat Ratings. The
Methodology & impressive return and lower volatility that result from segmenting stocks with
Portfolio Research lower ESG risk and a wider moat led us to construct a back-testable investment
strategy and portfolio. Based on the empirical results, we conclude that we have
found an effective and value-creating strategy by combining the two metrics.
Authors1
Key Findings
Dr Hendrik Garz ▪ Economic Moat Ratings and ESG Risk Ratings are negatively correlated: As
Executive Director, Methodology &
one moves up the ESG risk curve, moats become less frequent.
Portfolio Research
+49 69 9675 9098 ▪ For all five sources of economic moat (cost advantage, efficient scale,
hendrik.garz@sustainalytics.com intangible assets, network effects, switching costs), the share of companies
with low ESG risks is higher than the share of companies with high ESG risks.
Liam Zerter, CFA
▪ Looking at nine portfolios that we constructed based on intersections of
Senior Associate, Methodology &
Portfolio Research Economic Moat and ESG Risk characteristics, we found some striking
+1 416 861 0403 average return and risk patterns. Generally speaking, the wider the moat and
liam.zerter@sustainalytics.com the lower the ESG risk, the higher the average return of the portfolio and the
lower its volatility. Combining Economic Moat and ESG Risk delivered
superior results compared to each strategy individually.
▪ During COVID-19 markets (January to August): The highest return spread we
found was delivered by comparing the lower risk/wide moat bucket with the
higher risk/no moat bucket. The difference between the average returns of
companies in these two buckets is 22.8%(!).
▪ Over the three-year period from July 2017 to June 2020, negligible/low ESG
risk and wide moat companies have returned 55% to shareholders, while no
moat high/severe ESG risk companies have led to losses for investors of 20%.
The negligible/low ESG risk and wide moat companies group consistently
generated higher returns year after year.2 It also showed the lowest volatility
of returns over this period.
▪ We also looked at ESG momentum: Wide moat companies with positive ESG
momentum returned 13.1% per year, where companies with a wide moat and
a negative ESG momentum saw a decrease of -0.7%.
▪ We backtested a Wide Moat/Low ESG Risk Strategy for US equities and found
a cumulative return of 50% over our three-year investment period, significantly
outperforming the market as represented by the S&P 500 (34.3%) and a Wide
Moat Only Strategy (39.7%).
▪ Finally, based on Carhart’s Four-Factor Model, we estimated an alpha of 4.6%
per year using the factor premia of Morningstar’s North American Equity Risk
model.
 Methodology & Portfolio Research Combining ESG Risk and Economic Moat December 2020

A potent source of information
COVID-19 has amplified the investors’
interest in ESG integration
Introduction
A corporate ESG risk assessment is a rich and potent source of information for
investors. To which material ESG risks (e.g. Human Capital, Climate Change or
Water) a company is exposed to and how well it is managing this exposure, can
offer unique insights into it’s longterm economic viability. 3
While effective ESG risk management is certainly no guarantee of financial
outperformance, a growing body of evidence suggests that material ESG issues
can have a significant impact on equity returns.4 If anything, this idea has gained
further momentum in recent months, as the COVID-19 pandemic has led more
investors to consider ESG information, particularly social metrics, in their
investment processes.5

ESG factors play an important role in
investment analysis, but they do not
provide the full picture
However, while assessing corporate ESG risks may be useful, it ultimately does
not provide the full picture. There are many drivers of shareholder return that fall
outside of a typical ESG assessment, including a company's approach to pricing,
its M&A strategy, or its innovation pipeline. ESG factors can significantly
influence these matters, but they have not yet become central to mainstream
financial analysis. This is why portfolio managers who use ESG information
typically blend it with other types of information in their investment process, such
as traditional financial metrics or market price data.6

An Integrated Investment Approach

The five sources of economic moat It is precisely this type of integrated investment approach that we explore in this
research note. We do this by combining Sustainalytics' flagship ESG Risk Ratings
with Morningstar's Economic Moat Rating.7

While the ESG Risk Ratings measure the unmanaged risks of a company vis-à-
vis a set of financially material ESG issues,8 Morningstar's Economic Moat Rating
measures the durability of a company's competitive advantage and helps
investors identify companies that are likely to generate excess returns on
invested capital over twenty years or longer.9 Morningstar has defined five
sources of economic moat, as shown in Figure 1.

Figure 1: The Five Sources of Morningstar's Economic Moat

Cost Advantage Efficient Scale Intangible Assets Network Effects Switching Costs
Sustainably lower costs Dynamic in which a Includes brands, patents, and The value of a particular The cost of switching
than competitors. market of limited size is regulatory licenses. Brands good or service exceeds the expected
Irreplaceable process effectively served by few increases the customer's increases for both new value of switching. Price
advantages, superior companies. Incumbents willingness to pay, often through and existing users as not the only determinant.
location or access to generate economic positive association or reduced more customers use
unique asset. profits. Newcomers search costs. Patents protect that good or service.
discouraged from pricing power legally barring With each additional
entering because returns competition, but typically only for node, the number of
in the market fall below up to 20 years. Government potential connections
the cost of capital. regulations hinder competitors grows exponentially.
from entering the market, but
often require quid pro quo.
Source: Morningstar

2|Page
 Methodology & Portfolio Research Combining ESG Risk and Economic Moat December 2020

A company whose competitive advantage is likely to last at least twenty years is

classified as a wide moat; one that is expected to fend off its rivals for ten years
has a narrow moat. A firm with either no advantage, or one that is forecasted to
dissipate quickly, has no moat.

The Relationship Between ESG Risks and

Moats tend to be less common at
companies with high levels of ESG risk
Economic Moats
Before we focus on investment returns and risks, we are going to take a brief
look at the empirical relationship between ESG risks and economic moats. We
begin with sharing the results of a cross-sectional analysis of the ESG Risk- and
the Economic Moat Ratings within Morningstar's research universe of
approximately 1,500 companies globally as of 30 June 2020. As shown in Figure
2, these variables are negatively correlated: as one moves up the ESG risk curve,
moats become less frequent.

Only 3% of companies in the severe
ESG risk bin have a wide moat
To illustrate, about half (48%) of companies in the low ESG risk bin have a narrow
moat, and 16% have a wide moat.10 Examples include adidas AG, Cisco Systems
and Johnson Controls (narrow moat) and Microsoft, Hermes International, and
Royal Bank of Canada (wide moat).
By comparison, only one-quarter (25%) of companies in the severe ESG risk bin
have a narrow moat, and just 3% have a wide moat. 11 Examples include General
Electric, Chevron, and Sino Biopharmaceutical Ltd (narrow moat) and Foshan
Haitian Flavouring and Food Co, and Corteva (wide moat).

Figure 2: Distribution of Economic Moat Ratings by ESG Risk Category

100%
90% 15%

80% 37% 38%

45%
70%
71%
60%
50%
40% 85% 44%
48%
42%
30%
20%
25%
10% 16% 18% 13%
0% 0% 3%
Negligible ESG Low ESG Risk Medium ESG Risk High ESG Risk Severe ESG Risk
Risk
Wide Moat Narrow Moat No Moat

Source: Sustainalytics, Morningstar

ESG Risks and the Sources of Economic Moat

Controlling for industry effects
Figure 3 provides a more differentiated picture by distinguishing between the five
sources of economic moat. For our analysis we ranked companies by their ESG
risk at the subindustry level (based on Sustainalytics’ Industry Classification
System) and then allocated them into three roughly equally sized groups
(terciles). The ‘within-peers’ approach was chosen to control for industry effects.

3|Page
Methodology & Portfolio Research
For all five economic moat sources,
the share of companies with low ESG
risk is higher than the share of
companies with high ESG risk
Looking at moat frequency and ESG
risk by sector
Moat frequency and ESG scores are
negatively correlated
Combining ESG Risk and Economic Moat December 2020
The percentage represents the number of companies where we discovered a
specific moat source within the respective ESG risk tercile divided by the total
number of companies placed in that bucket. As one can see, the higher risk third
of companies have a lower likelihood of holding an intangible assets moat or
cost advantage moat when compared to the middle or lower thirds.
For companies in the bottom tercile in terms of ESG risk, i.e. companies with the
lowest ESG risk, 39% have an intangible assets moat, whereas only 27% of
companies in the top tercile have one. For all five economic moat sources, the
share of companies with low ESG risk is higher than the share of companies with
high ESG risk. In three out of the five cases there is a monotonous increase in
the frequency of high to low ESG risk .
Figure 3: Percentage of Companies with a Particular Moat Source
Switching Cost
Network Effect
Intangible Assets
Efficient Scale
Cost Advantage
0% 10% 20% 30% 40% 50%
Highest Third - ESG Risk Middle Third - ESG Risk Lower Third - ESG Risk
Source: Sustainalytics, Morningstar 12
ESG Risks and Economic Moats – the Sectoral View
Figure 4 segments the companies in Morningstar's coverage universe by sector
and shows each sector's moat vs. no moat distribution.13 The chart also provides
each sector's average ESG Risk Ratings. Sample sizes range from a low of 38
(Telecommunication Services) to a high of 219 (Consumer Discretionary) with a
mean of 134 companies. Although we should be cautious about drawing firm
conclusions due to low representation in specific sectors, some general trends
are apparent.
The proportion of companies with an economic moat, indicated by the gold bars,
ranges from 78% in Healthcare to 27% in Real Estate. Average ESG scores,
denoted by the teal line, extend from 36.3 in Energy to 17.2 in Real Estate. Moat
frequency and ESG scores across all eleven sectors are negatively correlated,
with a correlation coefficient of -0.20. As one moves down the moat curve, ESG
risks tend to go up.
4|Page
 Methodology & Portfolio Research
The trend plays out in the Energy
sector
Extremely low level of unmanaged
ESG risk
Real Estate bucks the trend
Combining ESG Risk and Economic Moat December 2020
Figure 4: Distribution of Economic Moat and ESG Risk Ratings by Sector
100% 40
Average ESG RIsk Ratings
35
80%
Economic Moat
30
Distribution
60% 25
Score
20
40% 15
10
20%
5
0% 0
Moat No Moat Average ESG Risk Ratings Score
Source: Sustainalytics, Morningstar
Energy is a case in point. It is the riskiest sector from an ESG perspective with an
average score of 36.3. Moreover, the proportion of firms in this sector with an
economic moat is relatively low at 37%. As a result, investors in the Energy sector
will find it a challenge to identify firms with a sustainable competitive advantage
that also exhibit low levels of ESG risk. Of the 90 Energy companies in
Morningstar's coverage universe, only three – Core Laboratories, Cheniere
Energy and Enbridge – have a wide moat rating and a medium ESG risk score
(there are no Energy firms with a negligible or low ESG risk score).
The Curious Case of Real Estate
The negative correlation between economic moats and ESG risk more or less
plays out in all sectors – with one exception. The Real Estate sector is
characterized by particularly low levels of unmanaged ESG risk. This is true not
only of Morningstar's coverage universe of 1,500 companies but also
Sustainalytics' comprehensive universe of approximately 4,000 firms. As shown
in Figure 4, it has an average ESG Risk Ratings score of just 17.2. Two of the
main reasons for this are the sector's limited involvement in ESG controversies
and the significant uptake of green building principles by REITs and Real Estate
Developers.14
Yet around one-quarter (27%) of Real Estate firms have a moat, which is the
lowest proportion of any sector and well below the pan-sector average of 57%.
In this particular sector, the interplay between ESG risk and sustainable
competitive advantage appears to be muted. Similar to Energy, the Real Estate
sector may pose challenges for investors looking to pursue a strategy based on
finding companies that simultaneously display attractive moat and ESG
characteristics.
5|Page
 Methodology & Portfolio Research
Looking at the COVID-19 period and at
longer-term performance
COVID-19 market environment – a
unique period to examine
ESG strategies performed
comparatively well during the initial
sell-off and subsequent recovery
Combining ESG Risk and Economic Moat December 2020
Combining ESG Risk and Economic Moat in an
Investment Strategy
We conclude that ESG risks and economic moats indeed seem to go hand in
hand, based on both, economic intuition and empirical evidence. However, does
it also pay off to combine them in an investment strategy? Is there a good reason
to assume that a strategy that seeks to select companies performing well in
Morningstar's Moat Rating and in Sustainalytics ESG Risk Ratings would
outperform? Does overlaying an ESG signal on top of a moat signal (or vice
versa) add any incremental value?
We approached this question in two ways. First, we looked at the year-to-date
performance numbers to see how moat and ESG strategies played out during the
COVID-19 sell-off and subsequent recovery. Second, we tested the strategies
over a more extended investment period stretching back to July 2017.
Moats, ESG and COVID-19
The COVID-19 period provides a uniquely instructive point in time to compare
companies' equity returns with different ESG risk profiles and degrees of
sustainable competitive advantage. Although the investment period is short, it is
characterized by one of the fastest drawdowns and rebounds in the history of
the global equity market. There is an apparent interest in understanding how
equity strategies of all types and flavors held up during this period.
It is well documented that ESG strategies performed comparatively well during
the February and March sell-off and subsequent recovery.15 Indeed, it is one of
the main reasons why investor interest in ESG integration has surged.
With the analysis in this research note, we provide additional insights into the
equity markets' behaviour during a unique period by looking at how an integrated
investment strategy based on both, Sustainalytics’ ESG Risk Ratings and
Morningstar’s Economic Moat Rating, performed. Figure 5 provides a summary
of our empirical results.16 The timeframe selected includes the beginning of 2020
and ends coincidingly when the global daily new COVID-19 cases began to
decelerate,17 and the S&P500 market recovered to near all-time highs seen earlier
in February. We see this as a prospective signal to the end of the first wave
impacts of COVID-19.
Figure 5: Average Returns of Stocks by ESG and Economic Moat Rating*
ESG Risk Category Economic Moat Rating Overall
None Narrow Wide
Negligible/Low -11.3% -3.6% 6.5% -4.9%
Medium -7.5% 0.3% 2.6% -2.3%
High/Severe -15.6% -8.1% -4.4% -11.6%
Overall -11.0% -2.8% 2.7% -5.3%
* Returns calculated from market close 31 December 2019 to market close on 6 August 2020
Source: Sustainalytics, Morningstar 18
6|Page
 Methodology & Portfolio Research
Wide moats and lower ESG risk
provide synergy in improving returns
further
Moat appears to be the more
consistent return driver ceteris paribus
Spreads between boundary
Positive return spread between lower
and higher ESG risk companies
Information Technology and
Healthcare propelled outperformance
Combining ESG Risk and Economic Moat December 2020
The returns are based on Morningstar's research universe of approximately
1,500 companies globally. Sample sizes range from a low of 36 (high/severe ESG
risk and wide moat category) to a high of 283 (medium ESG risk and narrow moat
category) with an average of 164 companies.19
Equity Returns During the COVID-19 Period
Several conclusions can be drawn from Figure 5 after observing the different
segmented combinations. First, the lower ESG risks and wide moats group of
companies yielded an average return of 6.5% over the COVID-19 period. On the
other hand, the combination of high/severe ESG risk and no moat resulted in a
substantially negative return of -15.6%.
The general pattern appears to be, the wider the moat and the lower the ESG Risk,
the higher the return. The difference between moat and ESG risk, however, is that
for the former, we found a strictly monotonous relationship between moat and
return. I.e., holding the ESG risk constant, average returns increase going from
the left (no moat) to the right (wide moat) for all three levels of ESG risk that we
have distinguished for this analysis. Holding moat levels constant, on the other
hand, yielded less coherent results. In particular, we found a bell-shaped pattern
for the no moat and narrow moat columns, i.e. medium ESG risks companies on
average delivered higher returns than both, lower ESG risks companies and
higher ESG risks companies.
We consider the most important observation to be that the differences in average
returns between the respective boundary buckets all have the predicted sign and,
hence, provide a consistent picture. All of them are also economically significant
with values ranging from 4.3 to 11.3 %-points.
Applying an ‘ESG Only’ Strategy
In Figure 5, the last column on the right-hand-side summarizes the average
returns of groups of companies reflecting different ESG risk levels independent
of a moat. The spread between lower and higher risk companies is +6.7% (the
difference between -4.9% and -11.6%). Lower ESG risk companies significantly
outperformed higher ESG risk companies, no matter whether they had a wide,
narrow, or no moat. The lower ESG risk bucket yielded a return of
-4.9%, with negative returns mainly due to a concentration in Real Estate and
Consumer Discretionary sectors, offset in part by investments in Technology and
Healthcare companies. The significant underperformance of the higher ESG risk
companies, on the other hand, was mainly driven by Energy and Industrial
sectors, alongside some underperforming Healthcare companies.
Applying a ‘Moat Only’ Strategy
The financial success of ‘Moat only’ strategies can be read from the bottom row
in Figure 5. Wide moat companies, for example, returned +2.7% to investors on
average, independent of their ESG risk level. This positive return is significantly
above the best performing ‘ESG only’ strategy that yielded -2.3% only. The wide
moat group is particularly heavily invested in specific peer groups such as
Software & Services, Healthcare, and Packaged Foods.20 Overall, the return
7|Page
 Methodology & Portfolio Research
Defensiveness from wide moat
companies and …
… adaptability from low ESG risk
companies
Successful stock selection during a
time of unprecedented disruption
Many well-known names
Looking at a three-year test period and
a sample of 799 companies
Combining ESG Risk and Economic Moat December 2020
spread between wide moat and no moat companies was +13.7%, i.e. twice as
high as the return spread implied by higher and lower ESG risk levels.
The ‘Hammer and the Dance’
The ‘hammer and the dance’ metaphor describes the Corona virus induced
period of lockdown as ‘the hammer’ and the following period of living with it as
‘the dance’.21
The beneficial returns of wide moat companies appear to be an answer to ‘the
hammer’ by governments worldwide as they shut down the economy with what
would be a metaphorical shield. COVID-19 created a sharp change of everyday
supply and demand dynamics; in such an environment, those companies with
inelastic demand, few competitors, durable pricing power, and that are integral
to other business's operations would fare best.
Companies with low ESG risks, on the other hand, are companies with
management teams that either have a more robust skill set in handling a diverse
platform of risk or are companies with fewer or less complex risk factors that
can negatively impact the business. Furthermore, strong ESG scores tend to
reflect superior adaptability levels, or, in other words, may showcase a more
robust set of ‘dance moves’ to survive through the pandemic.
Adding Value by Combining ESG Risk and Moat Signals
The highest return spread between any pair of the nine sub-groups shown in
Figure 5 is delivered by comparing the lower risk/wide moat bucket with the
higher risk/no moat bucket. The difference between the average returns of
companies in these two buckets is 22.1 %-points (!). Hence, it is safe to say that
the best performing investment strategy would have been to go long in the
former and short the latter.
Whether a coincidence or not, it is an empirical fact that investing in lower ESG
risk companies with wide moats delivered a high concentration of some of the
best subindustries to own during a time of unprecedented disruption to everyday
life. Among these are Enterprise and Infrastructure Software, Financial
Exchanges and Data Services, Data Processing, Semiconductor Equipment, and
Home Improvement Retail.
Wide moat and lower ESG risk names include Microsoft Corp, Adobe, Lam
Research, Mastercard, Pernod Ricard SA, Home Depot, West Pharmaceutical
Services, Sartorius Stedim Biotech SA, and Moody's. The combination also rules
out entire sectors in the Sustainalytics taxonomy such as Energy,
Telecommunications, Real Estate, and Utilities.
Longer-term Returns and Volatility
In the previous section, we focused on the short unique period that has been
characterized by the markets’ reactions to the COVID-19 pandemic. While this
analysis is certainly interesting and relevant as such, we would like to
complement the insights gained from this analysis by looking at a longer test
period. We opted to go for the three-year period extending from July 2017 to June
8|Page
Methodology & Portfolio Research
COVID-19 is not an exception for
performance
Comparison with Wide Moat Only
portfolio
A similarly consistent pattern also
emerged in terms of investment risk
as measured by the volatility of
returns
Combining ESG Risk and Economic Moat December 2020
2020. For our tests, we looked only at those companies that remained in the
same categories for both ESG risk and economic moat since the launch of the
Sustainalytics’ ESG Risk Ratings product in November 2018, providing us with a
sample size of 799 companies.
Note that making the assumption of continued category membership means that
our analysis results should not be interpreted as the outcomes of an
implementable investment strategy, but as an indication of systematic return
differences only. The three years we looked at are certainly a too short period to
draw definitive conclusions. Figure 6 highlights the annualized average return
generated each year from each group. The results are quite similar compared to
the COVID-19 period we examined previously.
Figure 6: Annualized (3YR) Returns by ESG and Economic Moat Rating*
ESG Risk Category Economic Moat Rating Overall
None Narrow Wide
Negligible/Low 1.5% 4.9% 15.8% 5.6%
Medium -0.6% 4.0% 8.4% 3.3%
High/Severe -7.0% 4.5% 8.5% -1.8%
Overall -2.3% 4.4% 11.0% 2.8%
* Returns calculated from 30 June 2017 to market close on 30 June 2020
Source: Sustainalytics, Morningstar 22
The findings are that negligible/low ESG risk and wide moat companies have
returned 15.8% per year (55% cumulatively) to shareholders, whereas no moat
high/severe ESG risk companies have led to losses for investors of -7.0% per
year (-20% cumulatively). On a side note, the negligible/low ESG risk and wide
moat companies group consistently generated higher returns in each of the three
years. Again, all boundary bucket comparisons delivered spreads with the
expected sign ranging from 0.4 to 15.5 %-points. In five out of six cases the return
difference amounts to more than 7 %-points.
We also analyzed the same companies listed in Figure 6, looking at returns for
the 2017 to 2019 timeframe, i.e. excluding the special COVID-19 circumstances.
The spread between the negligible/low ESG risk and wide moat group and the
high/severe and no moat group indeed shrunk (+20.5 %-points for the former vs.
+3.2 %-points for the latter), the general average return pattern, however,
remained in tact (see Figure 15 in the Appendix).
We conclude that the superior return characteristic of a lower ESG risk and wide
moat strategy are not limited to COVID-19 specific factors, but have root causes
that are more general in nature and are at work during different market regimes.
The assumption that, more longterm, systematic forces seem to be at work, is
also supported by the clear pattern that emerged when we looked at investment
risks over the same three-year period as represented by the volatility of monthly
returns. Figure 7 demonstrates that both ESG risk and economic moat are clearly
correlated with volatility following the intuitively expected pattern.
9|Page
Methodology & Portfolio Research
The combination of lower ESG risks
and wide moats provides the lowest
level of volatility
Looking at a sub-sample of 1,340
companies
Combining ESG Risk and Economic Moat December 2020
Figure 7: Annualized (3YR) Std. Dev. by ESG and Economic Moat Rating*
ESG Risk Category Economic Moat Rating Overall
None Narrow Wide
Negligible/Low 33.6% 29.0% 24.0% 29.8%
Medium 34.9% 30.4% 25.1% 31.2%
High/Severe 42.6% 29.9% 27.2% 36.3%
Overall 36.9% 29.8% 25.1% 32.0%
* Standard Deviation calculated from 30 June 2017 to market close on 30 June 2020
Source: Sustainalytics, Morningstar 23
For all three levels of ESG risk, our annualized volatility measure decreases
monotonously from the no moat bucket to the wide moat bucket, most
significantly so for the higher ESG risk companies from 42.6% to 27.2%. A less
striking pattern emerges when holding moat levels constant. The differences in
volatility are less significant and in one case (narrow moat level), the volatility for
the medium ESG risk companies is above that of the higher ESG risk companies.
However, for all three moat levels the volaltility differences between boundary
buckets are consistent and carry the a priori expected sign. Similar to the return
analysis presented above, the biggest spread (18.6 %-points) has been detected
for the two corner buckets with the higher ESG risk and no moat companies
displaying the highest level of volatility and the lower ESG risk and wide moat
companies showing the lowest one.
ESG Momentum & Economic Moat
So far, we looked at levels of ESG risk and economic moat. Prior research,
however, suggests that identifying companies with improving ESG ratings may
also deliver superior return and risk characteristics. 24 Hence, we also analyzed
the relationship between ESG Momentum and Economic Moat Ratings with
regards to average returns and volatility for 1,340 companies out of our total
sample of 1,500 companies.25
We defined ESG momentum as follows:
▪ Positive: A decrease in ESG risk score of 3.0 points or more;
▪ Negative: An increase in ESG risk score of 3.0 points or more;
▪ Neutral: A change in ESG Risk score between -3.0 and +3.0.
10 | P a g e
Methodology & Portfolio Research Combining ESG Risk and Economic Moat December 2020

Figure 8: ESG Momentum & Economic Moat – A Look at Returns and Volatility
ESG Momentum / Number of Annualized Annualized Average
Moat Category Companies (3YR) (3YR) Std. Change in
Returns Dev. ESG Risk
Rating Score
Wide Moat 217 11.5% 24.6% -0.51
Positive ESG Momentum 35 13.1% 22.6% -5.42
Neutral ESG Momentum 162 12.7% 25.0% -0.13
Negative ESG Momentum 20 -0.7% 24.9% 5.04
Narrow Moat 598 5.8% 29.6% -0.66
Positive ESG Momentum 107 8.0% 30.9% -5.49
Neutral ESG Momentum 446 5.7% 29.3% -0.06
Negative ESG Momentum 45 0.8% 29.9% 4.89
No Moat 555 -3.3% 36.0% -0.70
Positive ESG Momentum 104 -3.3% 39.5% -6.17
Neutral ESG Momentum 393 -2.4% 35.3% -0.16
Negative ESG Momentum 58 -9.1% 34.5% 5.49
* Returns and standard deviation calculated from 30 June 2017 to 30 June 2020 (market closing prices). The
average change in ESG Risk Rating is from Dec 2018 to June 2020. Economic Moat Rating is as of 30 June 2020.
Source: Sustainalytics, Morningstar 26

Positive ESG momentum shows some The 35 wide moat companies with positive ESG momentum returned 13.1% per
evidence of enhancing portfolio
year, while companies with a wide moat and a negative ESG momentum saw a
returns
decrease of 0.7%. Companies that saw a deterioration in their ESG Risk Ratings
score delivered negative returns emphasizing the importance of avoiding these
companies, much like companies with deteriorating moats.27
Adding a third dimension Adding a third dimension to our analysis, the ESG Risk Category, further improved
the return potential. The triple combination of positive ESG momentum with
negligible/low ESG risk and wide moat companies returned on average 21.4%
per year (see Figure 9). Some of the companies in this group included London
Stock Exchange Group PLC, Moody’s, Automatic Data Processing Inc, Canadian
Pacific Railway, CME Group, and Lowe’s.
Figure 9: Combining ESG Momentum, ESG Risk Categories & Wide Moat –
A Look at Returns and Volatility
ESG Momentum / Number of Annualized Annualized Average
ESG Risk Category Companies (3YR) (3YR) Std. Change in
Returns Dev ESG Risk
Rating Score
Low/Negligible 71 16.8% 23.9% -1.24
Positive ESG Momentum 13 21.4% 21.7% -5.69
Neutral ESG Momentum 58 15.8% 24.5% -0.24
Medium 113 9.6% 24.3% -0.09
Positive ESG Momentum 18 10.3% 22.5% -5.25
Neutral ESG Momentum 78 11.9% 24.7% -0.03
Negative ESG Momentum 17 -1.7% 24.5% 5.10
High/Severe 33 6.9% 27.1% -0.36
Positive ESG Momentum 4 -0.5% 25.9% -5.27
Neutral ESG Momentum 26 8.4% 27.2% -0.19
Negative ESG Momentum 3 4.7% 27.2% 4.65
Grand Total 217 11.5% 24.6% -0.51
* Returns and standard deviation calculated from 30 June 2017 to 30 June 2020 (market closing prices). The
average change in ESG Risk Rating is from Dec 2018 to June 2020. Economic Moat Rating is as of 30 June 2020.
Source: Sustainalytics, Morningstar 28

11 | P a g e
 Methodology & Portfolio Research
Taking the Morningstar Wide Moat
Focus TR USD Index as a blueprint
Some details of portfolio construction
Sub-portfolios rebalanced to equal
weight at the end of June and
December
Cumulative return advantage vis-à-vis
the market of 15.7%-points
Combining ESG Risk and Economic Moat December 2020
Creating and Backtesting a Low ESG Risk & Wide
Moat Index Portfolio
Portfolio Construction
Given the evidence that low ESG risk and wide moat companies have superior
risk-return characteristics, we attempted to validate these findings by
constructing a ‘real-world’ index portfolio that takes both factors into account in
portfolio construction. For this exercise, we used the Morningstar Wide Moat
Focus TR USD Index 29 as a blueprint and as a benchmark. The Morningstar Wide
Moat Focus Index provides exposure to companies with Morningstar Economic
Moat Ratings of wide that are trading at the lowest current market price/fair
value ratios as determined by Morningstar’s analyst team. The S&P 500 TR USD
served as the general market benchmark.
The construction of our Wide Moat/Low ESG Risk portfolio is based on two sub-
portfolios that have different reconstitution dates.30 For each sub-portfolio
reconstitution, we selected those 40 wide moat companies that displayed the
most favorable combination of value and ESG risk, unless a buffer rule limit
applied regarding sector weighting.31 In particular, using the Morningstar analyst
research coverage universe, we applied a 50% weight based on the percentile
ranking of the price/fair value average for the five days before each rebalancing
and a 50% weight on the percentile ranking of the ESG risk score at the day of
rebalancing. Constituents were equally weighted within their sub-portfolio on the
reconstitution dates. The companies selected needed to be domiciled in the US.
The index is denominated in USD.
The rebalancing of the sub-portfolios occurred at the end of June and December,
where the sub-portfolios were brought back to equal weight at 50%. Further
details regarding the index construction can be found in the Appendix. 32, 33
Backtest Results
Figure 10 shows the cumulative wealth created by investing in our Wide
Moat/Low ESG Risk portfolio starting on 30 June 2017 with a net asset value of
USD 10,000 and compares it to similarly calculated outcomes for our two
benchmarks, the moat-only and the market indices. Within this three-year time
frame between 30 June 2017 to 30 June 2020, the Wide Moat/Low ESG Risk
portfolio would have theoretically converted 10,000 USD into 15,001 USD over
the three-year investment period, yielding a cumulative return of 50%. This is by
and large what we would have expected based on the general risk-return
characteristics we reported on above.
12 | P a g e
Methodology & Portfolio Research Combining ESG Risk and Economic Moat December 2020

Figure 10: Cumulative Wealth Generated on a US$ 10,000 Investment

16,000

15,000

14,000

13,000

12,000

11,000

10,000

9,000
Jun 2017 Jun 2018 Jun 2019 Jun 2020
Wide Moat / Low ESG Risk Wide Moat Only S&P 500 TR USD

Source: Sustainalytics, Morningstar

The divergence vis-à-vis the two benchmark indices is quite significant: They
yielded cumulative returns of 40% (moat-only) and 34% (market). Furthermore,
as shown in Figure 12, the Wide Moat/Low ESG Risk portfolio experienced a
more subdued Max Drawdown and offered lower downside volatility.

Figure 11: Backtest Results – Selected Risk-Return Statistics*

Risk/Return Statistics Wide Moat/ Wide Moat S&P 500
Low ESG Risk Only

Cummulative Return 50.0% 39.7% 34.3%

Standard Deviation 18.0% 18.2% 17.6%
Sharpe Ratio 0.71 0.55 0.49
Loss St Dev 12.9% 13.7% 13.6%
Max Drawdown % -18.7% -20.1% -20.6%
* Based on full time period (from 30 June 2017 to 30 June 2020) Source: Sustainalytics, Morningstar

Wide Moat/Low ESG Risk portfolio
prefers higher ROA and ROE stocks
One notable feature of the Wide Moat/Low ESG Risk portfolio is that it favors
companies with a higher Return on Assets, a higher Return on Equity, and a
(slightly) lower price to free cash flow ratio (see Figure 12). A higher return on
equity signals that a potential source of outperformance might be from investing
in companies that can compound capital at higher rates of return. Return on
equity is a measure of growth in shareholder returns at the accounting level, and
the higher this ratio, the better the company is at generating wealth for its
shareholders.

Figure 12: Backtest Results – Selected Financial Ratios Statistics*

Statistics - Monthly Average Wide Moat/ Wide Moat S&P 500
(36 Months) Low ESG Risk Only

Price/Cash-Flow 12.4 13.5 13.3

Return on Assets 9.2% 7.2% 7.6%
Return on Equity 27.8% 21.3% 22.5%
* Based on 36 months averages Source: Sustainalytics, Morningstar

13 | P a g e
 Methodology & Portfolio Research
What are the sources of
outperformance?
The allocation effect is driving the
outperformance of the combined Wide
Moat/Low ESG Risk strategy
Interaction effect
Average annual turnover of 43.4%
Combining ESG Risk and Economic Moat December 2020
It seems apparent that adding low ESG risk to the Wide Moat Focus Index stock
selection process has synergistic capabilities to improve performance, but one
needs to be mindful that these results reflect only a three-year time frame.
Attribution Analysis
Figure 13 shows the results of an attribution analysis for the Wide Moat/Low ESG
Risk portfolio benchmarked against the Wide Moat Focus Index and the S&P 500
for the full-time period. An attribution analysis identifies sources of cumulative
excess returns (or active returns), i.e. returns that can be attributed to the active
investment decisions made.
Figure 13: Wide Moat/Low ESG Risk Portfolio - Attribution Analysis*
Attribution Allocation Selection Interaction Active
Benchmarks & Return Return
Gap
Wide Moat Only 13.9% -0.8% -3.0% 10.2%
S&P 500 11.2% 7.3% -3.1% 15.4%
* Based on the full time period (from 30 June 2017 to 30 June 2020) using cumulative arithmetic return.
Source: Sustainalytics, Morningstar
The results in Figure 13 show that it is the allocation effect, not stock selection,
that contributed most significantly to the Wide Moat/Low ESG Risk portfolio’s
cumulative excess return of 10.2% (vs. wide moat focus) and 15.4% (vs. S&P
500). The allocation effect reflects the success of the choices made at the
sector/industry level: Positive values indicate that a strategy can generate return
markups by deviating from the sector allocation in the benchmark portfolio.34
The stock selection effect, on the other hand, is slightly negative for the
comparison with the Wide Moat Focus Index, albeit insignificant. This means
that compared to the moat-only approach, adding the low ESG risk criterion in
stock selection does not help at the margin, i.e. after adjusting for sectoral
effects. In the comparison with the S&P 500, the selection adds to the cumulative
excess return on top of the allocation effect. This means that the combined Wide
Moat/Low ESG Risk strategy does not only pick the right sectors, but also the
right stocks within those sectors when compared to the market.
The interaction effect reflects the interplay between the allocation effect and the
selection effect. The return gap includes differences in sub-portfolio rebalancing
impacts as well as residual differences from dividend reinvestment. Its
moderately negative value for both cases indicates that our algorithm cannot
benefit from picking the right sectors and the right stocks at the same time.
Combining Moat and ESG Risk – A Strategy with Comparatively
Low Transaction Costs
Another advantage to the Wide Moat/Low ESG Risk portfolio is reduced turnover,
a likely result of introducing a secondary metric into the stock selection process,
which intuitively adds to diversification leading to lower volatility in rankings.
Furthermore, price to fair value is subject to volatility as it is a derivative of
company share price, while the ESG Risk Ratings are not dependent on market
movements. With the two portfolio rebalancing events over the three-year
14 | P a g e
 Methodology & Portfolio Research
Using the Carhart Four-Factor Model
to estimate abnormal returns
Combined strategy delivered a risk-
adjusted excess return of 4.6% p.a.
Negative momentum factor loading
Combining ESG Risk and Economic Moat December 2020
investment period, the average annual turnover for the Wide Moat/Low ESG Risk
portfolio amounted to 43.4%, which is comparatively low for a rule-based semi-
active approach.35
Combining Moat and ESG Risk – Is the Strategy Capable of
Generating Alpha?
The cumulative return advantage of the Wide Moat/Low ESG Risk portfolio vis-à-
vis the market and the Wide Moat Only strategy raises the question of whether
combining moat and ESG risk is a strategy that is also capable of generating
alpha, i.e. a risk-adjusted excess or abnormal return. To answer this question, we
ran a Carhart Four-Factor Model, regressing the portfolio’s excess returns
against Market-, Momentum-, Size-, and Value-Growth Factor premia.36 The
factor time series were sourced from Morningstar’s North American risk model.
The S&P500 was used as the market proxy and 1-month T-Bills as the risk-free
asset.37 The model was run for the same 36-month period (July 2017 to June
2019) we used previously. Figure 14 highlights the results below.
Figure 14: Estimating Alpha Using the Carhart Model - Regression Results*
* Based on the full time period (from 30 June 2017 to 30 June 2020). The R2 of the regression is 95.1%.
Source: Sustainalytics, Morningstar, Kenneth R. French - Data Library
The results confirm that combining wide moat and low ESG risk companies in a
portfolio strategy delivered a very attractive risk/return characteristic over the
past three years. The risk adjusted excess return amounted to 0.38% per month
or 4.6% per year. This is the portion of the portfolios return that goes beyond the
market- and the other factor risk premia. In other words, it is the portfolio return’s
portion that is not driven by size, value-growth or momentum factors. Selecting
stocks based on moat and ESG risk creates unique value in an investment
process. With a t-statistic of 1.6, the alpha also shows some statistical
significance. Even though the p-value is only 12%, we would place some
confidence in the result given the fact that the regression was run with just 36
observation points.
Interestingly, putting the market factor aside, only the Wide Moat/Low ESG Risk
portfolio loaded significantly on the momentum factor. The statistically negative
coefficient means that our strategy is underinvested in stocks that display
positive momentum as defined in Morningstar’s regional equity risk model. On
the other hand, it is not significantly tilted in terms of the size or value/growth
characteristics of the stocks it is invested in.
15 | P a g e
 Methodology & Portfolio Research
Wide Moat Only strategy displays a
generally similar characteristic, but
with a smaller and statistically less
significant alpha
Does the combination of ESG risk and
economic moat represent an
undiscovered systematic equity risk
factor?
Is there a causal relationship between
ESG risks and economic moats?
Combining ESG Risk and Economic Moat December 2020
Finally, we tested how these results compare to the Wide Moat Only portfolio and
found that they generally display quite similar characteristics. The alpha for the
combined strategy, however, is slightly higher (+0.84% p.a.) and statistically
more significant (t-value: 1.60 vs. 1.31). The full results for the Wide Moat Only
portfolio can be found in Figure 17 in the Appendix.
Conclusion & Outlook
All in all, our results are encouraging. Both metrics, ESG risk an economic moat,
work on a stand-alone basis as stock selection criteria, but even more
successfully when combined. Our results show that an integrated Low ESG
Risk/Wide Moat strategy has the potential to enhance portfolio returns, reduce
volatility, and create alpha beyond size-, value-growth-, and momentum effects.
We found that our results are not a COVID-19 anomaly, but also worked over a
longer investment period, both including and excluding COVID-19 markets. We
acknowledge that our test period is rather short, which is primarily due to the fact
that Sustainalytics’ ESG Risk Ratings have only been launched in 2018. We are,
therefore, committed to continuously monitor and update our empirical findings
going forward. One of the research questions we will turn our attention to is
whether the alpha we found will persist, which would support the notion of moat
and ESG risk representing a systematic equity risk factor. Much more work needs
to be done to test this hypothesis, with the most obvious need being the inclusion
of non-US equities in the analysis.
Furthermore, we encourage additional conceptual work to qualitatively better
understand the interplay between the two measures. For example: Do superior
capabilities of companies to manage material ESG risks help to create
sustainable competitive advantages or in other words economic moats? Or is it
the other way round? Does the existence of a moat put companies in the position
to afford investing into superior ESG management capabilities? When it comes
to ESG investment rationales, similar questions have been asked for many years
and have created heated debates between ESG believers and disbelievers. We
are optimistic that a look through the economic moat lens can help to solve the
puzzle.
16 | P a g e
Methodology & Portfolio Research Combining ESG Risk and Economic Moat December 2020

Appendix
Figure 15: Pre-COVID-19 Analysis - Annualized (3YR) Returns by ESG and
Economic Moat Rating*
ESG Risk Category Economic Moat Rating Overall
None Narrow Wide
Negligible/Low 8.6% 12.7% 20.5% 12.5%
Medium 9.1% 13.0% 15.9% 12.2%
High/Severe 3.2% 11.6% 18.2% 7.9%
Overall 6.9% 12.6% 17.8% 11.2%
* Returns calculated from 31 December 2016 to market close on 31 December 2019
Source: Sustainalytics, Morningstar 38

Figure 16: Pre-COVID-19 Analysis - Annualized (3YR) Std. Dev. by ESG and
Economic Moat Rating*
ESG Risk Category Economic Moat Rating Overall
None Narrow Wide
Negligible/Low 25.0% 23.8% 20.9% 23.8%
Medium 26.6% 24.4% 22.1% 24.7%
High/Severe 32.1% 23.9% 21.9% 28.0%
Overall 28.1% 24.1% 21.7% 25.3%
* Standard deviations calculated from 31 December 2016 to market close on 31 December 2019
Source: Sustainalytics, Morningstar 39

Figure 17: Estimating Alpha Using the Carhart Model - Regression Results*
Regression Statistics Coefficients Standard t-Statistic p-Value
Error
Wide Moat Only
Intercept 0.31 0.23 1.31 0.20
Momentum -0.56 0.21 -2.66 0.01
Size -0.05 0.22 -0.23 0.82
Value Growth -0.25 0.30 -0.84 0.41
Market 0.96 0.04 23.33 0.00
* Based on the full time period (from 30 June 2017 to 30 June 2020). The R 2 of the regression is 95.5%.
Source: Sustainalytics, Morningstar, Kenneth R. French - Data Library

17 | P a g e
Methodology & Portfolio Research Combining ESG Risk and Economic Moat December 2020

Portfolio Holdings as of 30 June 2020 (Post Reconstitution)

Figure 18: Wide Moat & ESG Index
Company Name Portfolio Company Name Portfolio
Weighting Weighting
Polaris Inc 3.3% Altria Group Inc 2.3%
Lowe's Companies Inc 2.8% Blackbaud Inc 2.3%
Masco Corp 2.7% John Wiley & Sons Inc Class A 2.3%
Adobe Inc 2.7% Berkshire Hathaway Inc Class B 2.3%
Guidewire Software Inc 2.6% Tiffany & Co 2.2%
S&P Global Inc 2.6% Biogen Inc 2.1%
Harley-Davidson Inc 2.6% Raytheon Technologies Corp 1.9%
Applied Materials Inc 2.6% Plains GP Holdings LP Class A 1.7%
Microsoft Corp 2.6% Autodesk Inc 1.6%
Salesforce.com Inc 2.5% Veeva Systems Inc Class A 1.5%
Yum Brands Inc 2.5% ServiceNow Inc 1.5%
CSX Corp 2.5% Emerson Electric Co 1.4%
Constellation Brands Inc A 2.5% KLA Corp 1.3%
Nike Inc B 2.4% Accenture PLC Class A 1.3%
The Western Union Co 2.4% State Street Corporation 1.3%
United Parcel Service Inc Class B 2.4% Charles Schwab Corp 1.3%
The Walt Disney Co 2.4% CME Group Inc Class A 1.3%
Deere & Co 2.4% Gilead Sciences Inc 1.3%
Comcast Corp Class A 2.4% Intercontinental Exchange Inc 1.3%
Starbucks Corp 2.4% JPMorgan Chase & Co 1.3%
Intel Corp 2.4% Kellogg Co 1.3%
Cerner Corp 2.3% Medtronic PLC 1.3%
Aspen Technology Inc 2.3% Philip Morris International Inc 1.3%
American Express Co 2.3% Wells Fargo & Co 1.3%
Bank of America Corp 1.1%
Source: Sustainalytics and Morningstar40

18 | P a g e
Methodology & Portfolio Research
Glossary of Terms
Economic Moat Ratings
ESG Risk Category
ESG Risk Ratings
Momentum Factor
Combining ESG Risk and Economic Moat December 2020
The concept of an economic moat plays a vital role not only in Morningstar’s qualitative
assessment of a firm’s long-term investment potential, but also in the actual calculation
of Fair Value Estimates. An economic moat is a structural feature that allows a firm to
sustain excess profits over a long period of time. Morningstar defines economic profits
as returns on invested capital, or ROICs, over and above the estimate of a firm’s cost of
capital, or WACC (weighted average cost of capital). Without a moat, profits are more
susceptible to competition.
▪ No moat: companies will see their normalized returns gravitate toward the firm’s cost
of capital more quickly than companies with moats.
▪ Narrow moat: companies that are more likely than not to achieve normalized excess
returns for at least the next 10 years.
▪ Wide moat: companies in which Morningstar analysts have very high confidence that
excess returns will remain for 10 years, with excess returns more likely than not to
remain for at least 20 years.
A company’s ESG Risk Ratings score is assigned to one of five ESG risk categories in the
ESG Risk Ratings:
▪ negligible risk (overall score of 0-9.99 points): enterprise value is considered to have
a negligible risk of material financial impacts driven by ESG factors;
▪ low risk (10-19.99 points): enterprise value is considered to have a low risk of material
financial impacts driven by ESG factors;
▪ medium risk (20-29.99 points): enterprise value is considered to have a medium risk
of material financial impacts driven by ESG factors;
▪ high risk (30-39.99 points): enterprise value is considered to have a high risk of
material financial impacts driven by ESG factors;
▪ severe risk (40 and higher points): enterprise value is considered to have a severe risk
of material financial impacts driven by ESG factors.
Note: Because ESG risks materialize at an unknown time in the future and depend on a
variety of unpredictable conditions, no predictions on financial or share price impacts, or
on the time horizon of such impacts, are intended or implied by these risk categories.
Sustainalytics’ rating framework that measures the extent to which enterprise value is at
risk, driven by environmental, social and governance (ESG) factors. The rating takes a two-
dimensional approach. The exposure dimension measures a company’s exposure to ESG
risks, while the management dimension assesses a company’s handling of these ESG
risks.
A company’s ESG Risk Rating applies the concept of Risk Decomposition to derive the
level of unmanaged risk for a company and is comprised of a quantitative score and a
related ESG Risk Category. The quantitative score represents units of unmanaged ESG
risk with lower scores representing less unmanaged risk. Unmanaged risk is measured
on an open-ended scale starting at zero (no risk) and, for 95% of cases, a maximum score
below 50. It is calculated as the difference between a company’s overall exposure score
and its overall managed risk score. For companies in the Comprehensive Ratings
framework, it can alternatively be calculated by adding the Corporate Governance
unmanaged risk score to the sum of the company’s issue unmanaged risk scores.
The momentum factor is one of the four factors of the Carhart four-factor model and
describes how much a stock has risen in price over the past year relative to other stocks.
A higher exposure to the momentum factor indicates the company has performed well
recently.
19 | P a g e
 Methodology & Portfolio Research
Size Factor
Sustainalytics Industry Classification
System
Value-Growth Factor
Wide Moat/Low ESG Risk Strategy
Wide Moat Only Strategy
Combining ESG Risk and Economic Moat December 2020
The size factor is one of the four factors of the Carhart four-factor model and describes
the market capitalization of a company. A higher exposure to the size factor indicates
smaller market capitalization.
Sustainalytics subindustries are defined as part of Sustainalytics’ own classification
system; the number of subindustries in the Sustainalytics subindustry classification
system is 138.
The value growth factor is one of the four factors of the Carhart four-factor model and
describes the aggregate expectations of market participants for the future growth and
required rate of return for a stock. A higher exposure to the value-growth factor indicates
higher growth.
A combination of using the ESG Risk Ratings and Economic Moat Rating metrics. Results
from segmenting stocks within the ESG Risk Ratings score of 19.99 or lower while
consecutively also receiving a wide moat rating under the Economic Moat Rating.
An investment strategy of using Economic Moat Rating metrics. Results from segmenting
stocks with a wide moat rating under the Economic Moat Rating.
20 | P a g e
Endnotesi
1
The authors would like to thank the following individuals for their feedback and inputs for this paper: Doug Morrow, Amrutha
Alladi, Madison Sargis, Jon Hale, Daniel Rohr, Patrick Wang, Adam Fleck, and Allen Good.
2
Values represent the average total return of the companies in each category from 30 June 2017 to 30 June 2020. Returns
calculated in base currency (also known as local currency).
3
Garz, H. and Volk, C. (2018), “The ESG Risk Ratings, Moving up the Innovation Curve, White Paper – Volume 1”,
Sustainalytics, https://www.sustainalytics.com/esg-research/thematic-reports/esg-risk-ratings-innovation/
4
Khan, Serafeim and Yoon (2015), “Corporate Sustainability: First Evidence on Materiality”, Harvard Business School,
https://dash.harvard.edu/handle/1/14369106

5
https://www.ft.com/content/81b267f4-414b-4c5a-b775-91c2f1a2f661

6
https://www.unpri.org/listed-equity/a-practical-guide-to-esg-integration-for-equity-investing/10.article

7
https://www.morningstar.ca/ca/news/193318/the-morningstar-economic-moat-rating.aspx

8
https://www.sustainalytics.com/esg-risk/

9
https://www.morningstar.ca/ca/news/193318/the-morningstar-economic-moat-rating.aspx

10
We highlight the low ESG risk bin because the negligible risk bin consists of only 13 companies. The low-risk bin consists
of 462 companies.

11
There are 91 companies in the severe-risk bin.
12
Values represent the average percentage of companies with a specific moat source. Thirds are identified by splitting
companies into three buckets by ESG Risk Ratings across each subindustry. Each bucket is inclusive of all subindustries.
Sample size of companies: 1,538.
13
We collapsed wide and narrow moat ratings together to maximize sample size.
14
https://globalaccess.sustainalytics.com/#/research/riskIndustry

15
https://connect.sustainalytics.com/esg-in-the-covid-19-recovery

16
Overall, we looked at the average returns of companies in 16 categories:

▪ Negligible/Low ESG Risk ▪ High/Severe ESG Risk

▪ Negligible/Low ESG Risk + No Moat ▪ High/Severe ESG Risk + No Moat
▪ Negligible/Low ESG Risk + Narrow Moat ▪ High/Severe ESG Risk + Narrow Moat
▪ Negligible/Low ESG Risk + Wide Moat ▪ High/Severe ESG Risk + Wide Moat
▪ Medium ESG Risk ▪ No Moat
▪ Medium ESG Risk + No Moat ▪ Narrow Moat
▪ Medium ESG Risk + Narrow Moat ▪ Wide Moat
▪ Medium ESG Risk + Wide Moat ▪ All companies
17
https://www.worldometers.info/coronavirus/#countries

i
Websites accessed last time on 25 November 2020.
 Methodology & Portfolio Research Combining ESG Risk and Economic Moat December 2020

18
Values represent the average total return of the companies in each category from 1 January 2020 to 6 August 2020. Returns
calculated in base currency.

19
Based on the 9 ESG + moat groups. Samples sizes are much larger in groups with only one criterion. All sample sizes are
provided below: Negligible/Low ESG Risk (475), Negligible/Low ESG Risk + No Moat (172), Negligible/Low ESG Risk +
Narrow Moat (231), Negligible/Low ESG Risk + Wide Moat (72), Medium ESG Risk (647), Medium ESG Risk + No Moat
(248), Medium ESG Risk + Narrow Moat (283), Medium ESG Risk + Wide Moat (116), High/Severe ESG Risk (355),
High/Severe ESG Risk + No Moat (184), High/Severe ESG Risk + Narrow Moat (135), High/Severe ESG Risk + Wide Moat
(36), No Moat (604), Narrow Moat (649), Wide Moat (224) and all companies (1,477).

20
Narrow moat stocks returned -2.8% to shareholders. This group clusters more around Information Technology companies
than any other with better returns from this sector than wide moat companies. However, it has broad exposure to Consumer
Discretionary companies, which is the main component of this group's negative returns.

21
https://medium.com/@tomaspueyo/coronavirus-the-hammer-and-the-dance-be9337092b56

22
Values represent the average total return of the companies in each category from 30 June 2017 to 30 June 2020. Returns
calculated in base currency. The sample population includes only those companies with the same Economic Moat Rating
through 30 Dec 2018 to 30 June 2020, and companies with an ESG Risk Rating category that is the same from 30 Dec 2018
to 30 June 2020. All sample sizes are provided below: Negligible/Low ESG Risk (267), Negligible/Low ESG Risk + No moat
(95), Negligible/Low ESG Risk + Narrow moat (126), Negligible/Low ESG Risk + Wide moat (46), Medium ESG Risk (330),
Medium ESG Risk + No moat (111), Medium ESG Risk + Narrow moat (155), Medium ESG Risk + Wide moat (64),
High/Severe ESG Risk (202), High/Severe ESG Risk + No moat (118), High/Severe ESG Risk + Narrow moat (62),
High/Severe ESG Risk + Wide moat (22), No moat (324), Narrow moat (343), Wide moat (132) and all companies (799).

23
Values represent the average standard deviation (returns calculated yearly) of the companies in each category from 30
June 2017 to 30 June 2020. Returns calculated in base currency.

24
https://corpgov.law.harvard.edu/wp-content/uploads/2019/03/esg-momentum_SGCIB.pdf

25
The reduction occurred because not all companies had a historical ESG Risk Ratings score with coinciding Morningstar
analyst coverage as of December 2018.

26
Values represent the average total return and average standard deviation (returns calculated yearly) of the companies in
each category from 30 June 2017 to 30 June 2020. Returns calculated in base currency. N = 1,370

27
We also analyzed strategies reflecting moat momentum. One noteworthy finding was that within the negligible/low ESG
risk and wide moat group isolated in Figure 6 (n=46), avoiding the five companies with a negative moat momentum could
have resulted in an additional 167 basis points in return per year for the grouping.

28
Values represent the average total return and average standard deviation (returns calculated yearly) of the companies in
each category from 30 June 2017 to 30 June 2020. Returns calculated in base currency. Wide moat companies only,
N = 217.

29
https://indexes.morningstar.com/our-indexes/equity/FOUSA06B9O; This index is replicated by the VanEck Vectors
Morningstar Wide Moat ETF and, hence, easily tradeable.
https://www.vaneck.com/ucits/etf/equity/moat/index/en/?country=uk&audience=retail

30
This is a technique to compress factor analysis within a narrower timeframe. It’s a way of removing any timing impacts
that might skew results, it also reduces turnover costs and makes sure the approach is applied more evenly across time
periods.

31
Note that we use the Morningstar sector taxonomy for our index construction and not the Sustainalytics sector taxonomy.
https://indexes.morningstar.com/resources/PDF/Methodology%20Documents/SectorArticle.pdf

32
https://assets.contentstack.io/v3/assets/bltabf2a7413d5a8f05/blt8ce7be0154196422/5eab287555fb0954c5ddef26/20
200416_ConstructionRulesWideMoatFocusIndex_final_(2).pdf

22 | P a g e
 Methodology & Portfolio Research Combining ESG Risk and Economic Moat December 2020

33
Some concessions and differences occurred to execute the model portfolio; this includes:

▪ The ESG Risk Ratings being a new product, does not have information before December 2018. To compensate for
this, we assume that the ESG Risk Ratings scores going back to 30 June 2017 were likely relatively close to what they
were in December 2018. For any calculations before December 2018, we use the December 2018 ESG Risk Ratings
scores as proxies.
▪ We used 30 June 2017, investible universe Morningstar US Market Index to screen out four companies not on our list.
Any company added to the economic moat research universe after this is assumed to pass the investible universe
rules as those companies with analyst coverage tend to be significant by market cap and liquidity.
▪ Rebalancing occurred on 30 June, 30 September, 31 December, and 31 March.
▪ Both ESG Risk Ratings scores, moat type, and price to fair value estimate from an analyst are required at the time of
reconstitution to be considered an investment option.
▪ 30 June 2017 was the start date of the portfolio; hence both sub-portfolios would be identical for the first three
months.
34
Over the respective timeframe, the Wide Moat/Low ESG Risk portfolio’s largest sector weightings were in the Consumer
Cyclical, Technology, and Financial Services sectors, with respective weightings of 22.3%, 21.1%, and 15.6%. The Wide
Moat Focus Index weightings for these sectors opposingly were 14.5%, 15.0%, and 13.2%. The more noticeable gap was
where the Wide Moat Focus Index averaged a concentration of 27.3% in the Healthcare sector, a far chasm from the Wide
Moat/Low ESG Risk portfolios 14.6% weighting. Energy, Utilities, Real Estate, and Basic Material sectors were insignificant
weightings for both the subject portfolio and the benchmark.

35
For comparison, the VanEck Vectors Morningstar Wide Moat ETF, which we used as a proxy for the Wide Moat Only index,
displayed an average annual turnover of 55.7% during the period from 2017 to 2019.

36
Over the past decade, in both academic literature and the quant practitioners’ world, this model has become the quasi
standard for measuring risk-adjusted abnormal returns, i.e. alpha. In technical terms, the Carhart α is nothing else than the
intercept (α) of the following four-factor regression: 𝑅𝑡−𝑅𝑓𝑡=𝛼+𝛽1∗𝑅𝑀𝑅𝐹𝑡+𝛽2∗𝑆𝑀𝐵𝑡+𝛽3∗𝐻𝑀𝐿𝑡+𝛽4∗𝑈𝑀𝐷𝑡+𝜀𝑡. 𝑅𝑡 is the
monthly return of an investment strategy portfolio and 𝑅𝑓𝑡 is the risk-free rate in month t. RMRF is the difference between
market return and the risk-free rate, SMB is the difference in return between a small-cap portfolio and a large-cap portfolio,
HML is the difference in return between a portfolio of high book-to-market stocks and one of low book-to-market stocks
and UMD is the difference in return between stocks with upward and downward share price momentum.

37
https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

38
Values represent the average total return of the companies in each category from 31 December 2016 to 31 December
2019. Returns calculated in base currency. The sample population includes only those companies with the same Economic
Moat Rating through 30 Dec 2018 to 30 June 2020, and companies with an ESG Risk Rating category that is the same from
30 Dec 2018 to 30 June 2020.

39
Values represent the average standard deviation (returns calculated yearly) of the companies in each category from 31
December 2016 to 31 December 2019. Returns calculated in base currency.

40
Statement of Ownership: Please note that at the time that this paper was published, authors of this report had positions in
some of the equities listed, specifically Microsoft, Aspen Technologies, and KLA Corporation.

23 | P a g e
Methodology & Portfolio Research Combining ESG Risk and Economic Moat December 2020

About Sustainalytics
Sustainalytics, a Morningstar Company, is a leading independent ESG and
corporate governance research, ratings and analytics firm that supports
investors around the world with the development and implementation of
responsible investment strategies. For more than 25 years, the firm has been at
the forefront of developing high-quality, innovative solutions to meet the evolving
needs of global investors. Today, Sustainalytics works with hundreds of the
world’s leading asset managers and pension funds who incorporate ESG and
corporate governance information and assessments into their investment
processes. Sustainalytics also works with hundreds of companies and their
financial intermediaries to help them consider sustainability in policies, practices
and capital projects. With 16 offices globally, Sustainalytics has more
than 650 staff members, including more than 200 analysts with varied
multidisciplinary expertise across more than 40 industry groups. For more
information, visit www.sustainalytics.com.
Copyright ©2020 Sustainalytics. All rights reserved.
The information, methodologies, data and opinions contained or reflected herein are proprietary of Sustainalytics
and/or its third parties suppliers (Third Party Data), intended for internal, non-commercial use, and may not be
copied, distributed or used in any way, including via citation, unless otherwise explicitly agreed in writing. They are
provided for informational purposes only and (1) do not constitute investment advice; (2) cannot be interpreted as
an offer or indication to buy or sell securities, to select a project or make any kind of business transactions; (3) do
not represent an assessment of the issuer’s economic performance, financial obligations nor of its
creditworthiness.
These are based on information made available by third parties, subject to continuous change and therefore are
not warranted as to their merchantability, completeness, accuracy or fitness for a particular purpose. The
information and data are provided “as is” and reflect Sustainalytics` opinion at the date of their elaboration and
publication. Sustainalytics nor any of its third-party suppliers accept any liability for damage arising from the use
of the information, data or opinions contained herein, in any manner whatsoever, except where explicitly required
by law. Any reference to third party names or Third-Party Data is for appropriate acknowledgement of their
ownership and does not constitute a sponsorship or endorsement by such owner. A list of our third-party data
providers and their respective terms of use is available on our website. For more information, visit
http://www.sustainalytics.com/legal-disclaimers.

Sustainalytics
info@sustainalytics.com
www.sustainalytics.com

24 | P a g e