The coronavirus outbreak caused global stock markets to plunge and meant the value of our personal investments fell with them. Markets dropped to their lowest levels since the 2008 financial crisis as a result of the pandemic. While there has been some recovery, this has been limited and volatile.
But some stocks and funds are weathering the downturn better than others – and they have one thing in common. Experts are unanimous that the returns from snappily titled environmental, social and governance (ESG) investments are outperforming standard holdings during the pandemic. In fact, companies with the highest ESG scores are performing more than 10 percentage points better than those rated least, according to some analysts.
While ESG investing has been gaining popularity, it still only accounts for 1.5% of invested cash, according to investment firm Kames Capital. Some investors have been slow to adopt ESG because of a belief the sector was relatively untested and not as profitable as more mainstream options.
What are environmental, social and governance (ESG) investments?
Definitions vary, but broadly ESG is a set of positive attributes that a company can have. For example, a company or fund with a high ESG score might have initiatives to offset carbon emissions, be committed to equal opportunities in the workplace or avoid industries commonly regarded as unethical such as arms manufacture or the production or sale of addictive substances.
Some ethical funds pick their investments through ‘negative screening’, which means they filter out gambling firms or companies that produce goods such as tobacco.
Others use ‘positive screening’ and invest in companies that make a positive ESG impact – for instance, by having good human rights, labour rights and equality records.
Changing views on ESG
The coronavirus outbreak appears to be helping to shatter that myth.
Rob Morgan, investment analyst at investment platform Charles Stanley Direct, says: “The evidence is clear that worries about underperformance of this form of investing are misplaced.”
In fact, around 48% of investors told Charles Stanley they planned to increase their exposure to ESG and socially responsible investments.
The way ESG funds weather the pandemic could see them shake off their underdog status for good, according to Gina Miller, co-founder of wealth manager SCM Direct.
Miller says: “The pandemic is dividing opinion in terms of attitudes to ethical investing, and while it is true that ethical investing is still in its infancy, this is arguably the first true test for many ESG funds. Their performance during this period could well shape investors’ tolerance for them in the future.”
While ESG investments have performed better than their peers on average, sadly this generally means they just lost less money.
Fidelity International says the S&P 500 fell 26.9% on average between 19 February and 26 March. The investment firm tracked 2,600 companies and found that the share price of those it rated A – the highest – for ESG issues fell 23.1% during the same period, while those rated E fell 34.3%.
Other experts identified a similar pattern. Moneywise’s parent company, interactive investor, says ethical funds outperformed non-ethical rivals this year, including the start of this crisis. In the US, ii says the ethical FTSE4Good US Index lost 11.7% from 1 January until 24 March, compared to losses of 14.5% for its relatively non-ethical rival, the FTSE USA. In the UK,
the ethical FTSE4Good UK Index lost 27.7% over the same period, while the FTSE All Share Index lost 28.5%.
Experts are divided on why ethical investments are faring better, but there are a few theories.
Myron Jobson, personal finance campaigner at interactive investor, says this is due to the areas they invest in.
“It would be wonderful to think the increase in assets held in socially responsible funds and investment trusts on interactive investor reflects the growth of ethical investing more broadly,” says Jobson.
“But in such a short space of time, it most likely reflects the fact that ethical propositions have held up a little better than the wider market. Nevertheless, this is further proof, were it needed, that investing for good doesn’t have to mean sacrificing performance.”
Others say the recent high performance of ESG companies and funds is more due to the flip side of the coin – what they choose to ignore.
Many of these funds avoid investing in fossil fuels due to their environmental impact. As a result, these funds have been protected from a huge drop in oil prices recently.
Oil prices fell in April as the coronavirus outbreak curbed demand around the globe, and talks broke down between Russia and the oil cartel OPEC (Organisation of Petroleum Exporting Countries) over limiting production. Prices fell from over $50 per barrel at the start of March, to close to $20 at the end of the month. In fact, for a short period prices technically turned negative.
Ethical funds also often exclude mining stocks, and the share price of many of these companies has dropped due to a shrinking demand for non-petroleum natural resources, according to Charles Stanley Direct.
But others say the higher performance of ESG funds is due to good management. These funds have to be highly analytical to strip out non-ethical investments. This focus on scrutiny requires a high-calibre management team, which is good for all parts of the fund.
Jenn-Hui Tan, global head of stewardship and sustainable investing at Fidelity International, says: “Our thesis, when starting the research, was that the companies with good sustainability characteristics have better management teams and so should outperform the market, even in a crisis. The data that came back supported this view.”
ESG’s loyal following
The good performance of ESG has not been lost on those investors who are in the know. Ethical investors have stayed faithful to their funds despite the downturn, with relatively few panicking and pulling their money out.
Morningstar Manager Research found that investors put €30 billion (£26.4 million) into sustainable funds overall in the first quarter of 2020 but pulled out £123 billion from standard funds. The company says this is because ESG investors tend to be less flighty than average and more likely to sit tight during market slumps.
Hortense Bioy, European director of passive strategies and sustainability research at Morningstar, says: “The continued inflows in first-quarter 2020 speak of the stickiness of ESG investments. Investors in sustainable funds are typically driven by their values, invest for the long term, and seem to be more willing to ride out periods of bad performance.”
The big winners were those funds that set out their stall as being environmentally aware or focused on tackling climate change, according to Morningstar.
Avoiding ‘sin stocks’
ESG investments are not just a smart idea during the coronavirus stock market slump. In fact, funds that avoid so-called ‘sin stocks’ are far more likely to have beaten their peers over at least the past five years, according to Morgan.
To prove this, Charles Stanley filtered out the ESG and sustainable funds from the Investment Association UK All Companies and Global sectors and then compared them to the average performance of all the other funds in these sectors.
It found that the UK All Companies ethical funds underperformed the FTSE Allshare index by 12.8% over the past 12 months, compared to a 19.5% loss for non-ethical funds.
Over three years the ESG funds would have undershot by 0.4%, compared to their rivals’ -11.1%.
But over five years the figures are a 9.1% overperformance for ethical funds and a 0.1% underperformance for normal funds, while over 10 years the numbers are an index-beating 82.6% and 63.4% respectively.
The picture is slightly different globally, but ethical funds still trumped standard ones for the past five years. Over 12 months, global ESG funds undershot the MSCI World index by 10.8%, but non-ethical funds missed it by 13.7%.
Ethical funds worldwide beat the index by 2% over the past three years (non-ESG funds: -3.6%), 24.7% over three years (non-ESG funds: 13.2%) and 39.2% over five years (non-ESG funds: 36.9%). This pattern is only broken when the last 10 years are analysed when global ESG funds outperformed the index by 98.4% but their more standard peers managed to beat this and overachieved by 118.9%.
Experts expect ESG investments to become more popular. Recent weeks have shown the value of sustainable supply chains, of having robust corporate governance and good business practices.
Asset managers also expect demand in Europe for ESG investments to rise over the next one to two years at least, according to an April report from financial researcher Cerulli Associates.
A Cerulli spokesperson says: “ESG thematic funds are increasingly popular with European investors, who are increasingly open to the narratives behind such products.”
Charles Stanley Direct thinks this will be driven by a growing environmental awareness.
Morgan says: “As society becomes more acutely aware of the need to solve environmental and social issues, companies that help us do so are well placed to grow. This could be from the opportunities that arise from the creation of a more sustainable and low-carbon economy, or from solving other pressing issues facing society.”
One way or the other, it seems that clunky acronym is here to stay.