ESG investing provides shelter in the storm

Stockmarkets’ stumble last week fuelled fears of another sharp setback. So it’s perhaps worth revisiting the initial outbreak of turbulence in March to gauge what type of fund managed to provide some downside protection. The short answer is: not much at all bar some technology-focused funds. Pretty much every asset class plummeted.

Nonetheless, interestingly, one strategy does appear to have provided some comfort: investing in environmental, social and governance (ESG, see page 15 for a full definition) funds. They slipped during the sell-off, but their relative outperformance was striking.

The evidence piles up

MSCI runs a hugely popular index of world stocks, the MSCI ACWI index, which also features a variation called the ESG Leaders index. This has been outperforming the main index for years, but by 16 March that outperformance had hit record levels. Another index and research outfit, Morningstar, has compared 26 ESG index funds’ returns between 13 February and 13 March 2020 with those of their conventional peers. Returns were higher for 85% of ESG ETFs in the US market and for 100% in the context of non-US developed-market stocks.

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One key measure looks at fund-flow data. French investment bank Societe Generale says that “ESG was the only equity strategy showing positive flows in the market downturn in March and... positive flows in April”. Anne Richards, the CEO of mega-fund manager Fidelity, says that the price of a share in companies with a “high (A or B) Fidelity International sustainability rating dropped on average less than the S&P 500 from its 19 February peak to 26 March. Those rated C to E fell more.”

On average, among the 2,689 companies rated, each ESG rating level was worth an additional 2.8% of stock performance compared with the index.

Analysts have several explanations for this. Many ESG funds were bullish on growth stocks, quality stocks, and healthcare-tech stocks, all of which outperformed. But most ESG funds are bearish on capital-intensive industrial and energy stocks, which plunged.

As these stocks become more expensive, they might fall out of favour and cheaper value stocks could catch up. But ESG funds’ longer-term future may still be rosy. Professor Chendi Zhang of the University of Exeter Business School has led a study measuring the performance of US stocks in the first quarter of 2020. In the three weeks between the start of the market decline and the US government’s bail-out package, firms with high ESG ratings outperformed those with low ones by 7.2%.

It seems corporate level ESG policies “are as valuable in creating resilience as cash”, which Professor Zhang described as “extraordinary”. The key may be consumer attitudes: “credible ESG policies tend to attract more loyal customers, [implying] less need to compete on price”.

Building a brand

This sounds credible and reinforces the idea that ESG burnishes brands, which in turn transforms ESG firms into a new form of quality stock – the type of stock that can become overpriced for extensive periods of time.

Analysts at Killik & Co highlight the bigger picture: the regions in China, Italy and the UK worst-afflicted by Covid-19 tend to be areas with high atmospheric road pollution. So climate change and adaptation to a post Covid-19 world become the same concern. More broadly, the push towards a greener, cleaner world will drive the “greatest reallocation of capital of the 21st century”. And of course, gold rushes have a tendency to create their own forward momentum. So if the markets do take another tumble, ESG funds could be a defensive way of playing several trends at once.

I wish I knew what ESG investing was, but I’m too embarrassed to ask

Environmental, social and governance (ESG) investing – and similar approaches such as socially responsible investing (SRI) – aim to make money while avoiding firms viewed as having a negative impact on the world and encouraging those that have a positive impact.

Traditionally, ethical approaches to investing mostly focused on not buying any companies in businesses that the investor dislikes (known as exclusionary screening). This often included vice stocks, such as tobacco, gambling or alcohol. Some investors might aim to invest more in industries that they view as beneficial (such as renewable energy), although this was less common. However, as demand for ethical investing has become greater, this has evolved to include approaches where the investor takes into account whether a firm is trying to follow the highest standards they can within their sector. Hence an oil producer or a miner would not necessarily be ruled out in some funds or portfolios that follow ESG mandates, so long as the firm is attempting to minimise the adverse impacts of what it does. Some ESG investors will also engage with firms to try to pressure them to follow more sustainable practices, rather than simply not investing in them.

Environmental factors are probably the first thing that many investors associate with these kinds of investing strategies – from climate change to air and water pollution to biodiversity. Social issues are perhaps the broadest and the hardest to measure: they can include how the firm deals with customers, labour standards and human rights in its supply chain, or matters of gender, diversity and equal rights in its workforce. Governance is the strand that is most closely associated with traditional investment analysis: it includes issues such as executive pay, fair treatment of minority shareholders and questions of business conduct, such as bribery and corruption.