Can ESG outperformance continue?

ESG funds outperformed during the crash of Q1 and the rebound of Q2. What's next?

Fund selectors have said the outperformance of ESG investments against comparable conventional peers has “much, much further to run” as the Covid-19 pandemic has accelerated changes in behaviour and attitudes towards sustainability

Sustainable funds enjoyed significant outperformance during the first quarter of the year amid a backdrop of extreme volatility as the impact of coronavirus unfolded around the world.

SRI funds in the Investment Association’s UK All Companies sector posted a loss of 21.8% over the three months to 20 April, while Non-SRI UK All Companies funds lost 25.6%, according to figures from Charles Stanley Direct. The FTSE All-Share fell 24%.

Similarly, from a global perspective, SRI Global funds dropped 10.8%, compared to falls of 13.7% in Non SRI Global fund and 13.5% from the MSCI World index.

This equity outperformance continued into the second quarter; and in the report Sustainable Stock Funds Held their Own in Second Quarter Rally, Morningstar’s director of ESG research for the Americas Jon Hale, saidan impressive” 72% of sustainable equity funds listed in the US ranked in the top halves of their Morningstar Categories, and all 26 ESG index funds outperformed their conventional index-fund counterparts.

“After clearly outperforming their peers on a relative basis in the first-quarter downturn, the opposite might have been expected in the second, as stocks posted their best quarter since 1998,” he wrote.

 “Nevertheless, 56% of sustainable equity funds managed to rank in their category’s top half for the second quarter. “Breaking it down by quartiles, 28% ranked in the top quartile of their categories while only 19% finished in the bottom quartile. Thus, sustainable equity funds were once again overrepresented in the top quartiles and top halves of their categories.”

H1 outperformance

First quarter returns for sustainable funds were bolstered by underweights in energy, some of which were the worst performers, and overweights in healthcare and technology, sectors which found themselves at the centre of attention as the coronavirus infected millions around the world, causing lockdowns – and a swift move to remote working – in a bid to slow the spread.

However, Hale said the following quarter held headwinds for  sustainable funds as energy became the top-performing sector in the US.

He added: “Moreover, stocks with attractive ESG profiles that proved more resilient in the first quarter might have been expected to generate more modest returns in the rally than stocks that had experienced greater first-quarter losses.”

The opposite has been true; sustainable funds have held up through two very different market environments, as pointed out by UBS in its latest Sustainable Investing Perspectives note authored by sustainable investing strategist Amantia Muhedini and team.

It said: “[Sustainable investment strategies] are not only not only showing defensive characteristics amid uncertainty and volatility, but also maintaining relative outperformance through a sharp market recovery.”

It added sustainable themes continue to provide “favourable return potential”.

“We expect this to be supported by the post-Covid-19 green recovery that increasingly looks to be supported by policymakers in many parts of the world.”

Patrick Thomas, head of ESG investing at Canaccord Genuity Wealth Management and ESG Clarity editorial panellist, said the outperformance through both quarters has been “sector and style driven”.

“Most funds that are genuinely incorporating ESG analysis into their investment process would be overweight in sectors like technology, healthcare and consumer staples and heavily underweight in energy and banks. Despite a more cyclical rally for parts of Q2, this did not really change. Or to think in terms of style, growth strategies have outperformed and continue to outperform value,” he said.

Additionally, Fred Kooij, CIO at Tribe Impact Capital, said companies with higher ESG credentials tend to perform because of those very credentials.

“It’s less easy to quantify, but we believe ESG has outperformed because those businesses who have already committed themselves to ESG have succeeded in reducing operational risk and built in greater resilience due to better relations with employees, better managed and more reliable supply chains, and a lower risk to their overall business reputation. As a consequence, these businesses have been able to protect their earnings better and this realisation has gained wider acceptance and reward as the year has progressed.”

Sustainable themes

In a recent analysis piece from ESG Clarity‘s quarterly digital magazine, ESG investing leads charge in race to kickstart economy, commentators discussed how, with ESG-friendly elements of lockdown now ingrained in our futures, those companies placing sustainable practices at the top of their agendas will spearhead the global recovery from the Covid-19 crisis.

Furthermore, however, fund selectors are forecasting ESG outperformance to continue as behaviours are changing and adapting for a ‘new normal’.

Tribe’s Kooij explained ESG-friendly companies are “benefitting from the real or perceived changes in future behaviour and policy direction which have been catalysed or accelerated by the shutdown.”

He added they have earnings resilience but are also benefitting from investors discounting higher growth, which is occurring faster.

“This has been noticeable in technology, for example, as a result of remote working, but also in building efficiency, circular economy and renewable energy as public pressure has been pushing government policy for a clearer, targeted response to build back economies in a more sustainable and resilient fashion,” he said.

James Clark, senior fund analyst at Hawksmoor Investment Management, shared this view, noting Covid-19 has shone a spotlight on investment themes including health, well-being, safety, resource efficiency and clean energy infrastructure.

“These themes were already prevalent in many sustainable investment strategies (and in some cases have been present for decades) and are perhaps now being rewarded more so than ever before.”

Future performance

Clark added he anticipates sustainable investment strategies to continue to outperform as Covid-19 has accelerated changes in behaviour and attitudes towards sustainability, which were already underway before the pandemic hit.

“Sustainable themes have much, much further to run,” he said.

Thomas agreed adding that we have already seen evidence of companies with better ESG ratings outperforming the worst, and because of the type of businesses it exposes you too.

“ESG done properly is an excellent way of getting exposure to disruptive innovation in a variety of different parts of the economy. These drivers (climate transition and the need for economic growth to work for a greater number of people) are structural rather than cyclical and the key themes will not change. 

“Companies that manage ESG issues well are simply better investments and the market knows it,” he said.

There is a note of caution, however, from Kooij said outperformance will be more difficult as ESG becomes a larger segment of the market.

“There is a risk with ESG investing that active and especially passive managers become too reliant on third party data providers who are unable to uncover all the operational nuances of a company and don’t disclose precisely what a company does.

“The limitation with ESG is that it is not specifically geared towards identifying the positive change makers that differentiates impact investors and can unlock the alpha we believe is deliverable by focusing more strictly on companies that have sustainability and responsibility embedded into the actual goods and services they produce. This recurring theme has been highlighted again this year with companies in the coal mining and fast fashion space receiving strong ESG scores and purchased by some ESG funds which have been hurt when share price performance has been weak.”


Natalie Kenway

Natalie is editor in chief at MA Financial covering ESG Clarity, Portfolio Adviser and International Adviser. She was previously global head of ESG insight for ESG Clarity and has been an investment journalist...