As pandemic rages on, ESG funds shine brightly

Among the positives is the strength of investment strategies designed around environmental, social, and governance criteria which have been holding up in terms of relative performance.

Among the positives is the strength of investment strategies designed around environmental, social, and governance criteria which have been holding up in terms of relative performance even as the fast-spreading virus was taking down the financial markets.

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Morningstar’s sustainability ratings system that ranks portfolios from one to five globes, based on the asset-weighted risk scores of the underlying holdings, found that funds with the highest ESG ratings not only outperformed funds with the lowest ESG ratings, but also outperformed the broader market.

During the first quarter, when the S&P 500 Index fell by 23.6%, global large-cap stock funds with the top rating of five globes had an average decline of 17.7%. On the other end of the spectrum, funds in the same category with a Morningstar rating of one globe lost 26.6% during the quarter.

Morningstar globe ratings provide a unique look at ESG investing because the globes are awarded not based on how a fund’s strategy is described in the prospectus or what the fund is named, but rather on the actual portfolio holdings and investing history.

Focus on ESG issues

“The globe ratings reflect how well a fund’s holdings are doing on the material ESG issues effecting their business. A company with low ESG risk is one that handles and is able to address ESG issues and that minimizes the risk to the firm,” said Jon Hale, Morningstar’s global head of sustainability research.

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Regardless of where one sits on the ESG investing continuum, a global pandemic was not likely cited as a reason to invest in strategies built around portfolio exposure to various sustainability criteria. Though there is some recent precedent for ESG strategies holding up on a relative basis during a sudden market downturn.

In the fourth quarter of 2018, when concerns over a trade war with China drove the S&P down 13.5%, the average sustainable U.S. equity fund tracked by Morningstar beat the index by a full percentage point.

“Once you start picking through the numbers and looking under the hood, in both periods there was a flight to quality,” said Martin Jarzebowski, director of responsible investing at Federated Hermes.

‘New quality factor’

“ESG is starting to be understood as the new quality factor, and when you think of quality you think of strong management teams, balance sheet strength and companies positioned for the long term, he added. “When you’re seeing market contractions and a flight to quality, ESG strategies are holding up.”

Part of the strength of ESG strategies in the current downturn can be attributed to the fact that most ESG funds have limited exposure to the fossil fuel industries, which have suffered so far this year. But that alone is not enough to explain the performance disparity, especially since fossil fuels make up a small percentage of a broad market index.

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“ESG means a lot more than just fossil fuel-free. It’s also about where you direct capital, and how well you understand liabilities,” said Chat Reynders, chairman and chief executive of Reynders, McVeigh Capital Management.

“The ESG data is still imperfect, but it will get better as people learn what’s material and how liabilities uncover themselves,” he said. “It’s important to understand that sustainability means more than just environmental stuff, and as a business it means weathering the darkest storm.”

Clear strength

John Streur, president and chief executive of Calvert Investments, said even though “no company really had criteria for managing during a pandemic, it’s clear that companies that have the criteria for ESG reacted well during this downturn.”

[Video: By the Numbers: COVID-19 and ESG]

“COVID-19 risk is very similar to climate change,” he said. “This is a problem of human psychology, because we have a difficult time of dealing with risks that are right in front of us.”

In terms of how ESG research and analysis applies during the current pandemic, Streur said a company’s vulnerabilities are exposed under the same kinds of ESG criteria.

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“We know some companies have really stepped up and showed leadership in response to this,” he said. “Companies are making day-to-day decisions about how they’re able to treat people at the company when the company is not open for business. This will form the company for many years to come, and will form the brand value.”

Touching both ends of the spectrum in terms of how companies are working through the pandemic, Streur cited cruise line company Carnival Corp. (CCL) and Walmart Inc. (WMT).

Learning from challenges

Carnival has a history of safety challenges and weak ESG performance, he said.

“And this is a company that continues to make decisions about maintaining business operations (during the pandemic) while seeing problem after problem. Their history of safety issues has really played out in a tragic way,” Streur said.

[More: COVID-19 response reinforces values of sustainable investing]

Walmart, on the other hand, is an example of a company that learned during Hurricane Katrina about the critical role of helping employees and the community, in many cases even before the government could help, he said. “Once again, we’re seeing Walmart taking a leadership role.”

Translated into stock performance, consider that Carnival shares fell by 73.6% during the first quarter of this year, while Walmart shares fell by 4.7%.

“This situation really makes the point that nonfinancial risk factors can have a massive impact on portfolio value,” Streur said. “Longer term, as a society, we’ll be thinking about what else is out there. What other nonfinancial risks are sitting out there that could really impair the value of a portfolio. If anyone was lagging, in terms of getting ESG research into the portfolio, this is a massive wakeup call.”