ESG appeal survives test of market pullback

A focus on ESG diverts attention from investment performance, especially in times of market volatility, according to a recent Morningstar study.

A silver lining from the pandemic-triggered stock market pullback in March is that it provided an ideal environment for Morningstar to test investor discipline and priorities during extreme market conditions.

The high-level findings from the study of a cross-section of 626 investors in late March, immediately after the S&P 500 Index had dropped 30% over four weeks, shows that a focus on environmental, social and governance issues can effectively work to divert investor attention away from investment performance.

Financial advisers will recognize that as a good thing most of the time, but especially during times when economic and market conditions are cloaked in uncertainty.

“This research really points to the idea that this can be a new way of talking to clients about investments, and it can be a way to nudge investors to not overly fixate on returns,” said Samantha Lamas, head of behavioral research at Morningstar.

The volunteers, selected to represent the U.S. population of investors, were asked to imagine they had started a new job and were setting up their retirement-saving account from a menu of 15 fund options. The participants were also randomly assigned to three different groups, each representing a different level of information on the underlying funds.

Group 1 participants were provided with standard Morningstar fund metrics related to fund categories, expenses, and performance.

Group 2 participants were given the basic metrics in addition to Morningstar’s sustainability ratings for each fund.

Group 3 participants were first asked about their personal preferences regarding ESG issues to prompt a focus on non-financial aspects of the funds. The participants were then given the same information provided to Group 2 participants.

According to Lamas, the core question across the three groups was did people pay attention to ESG information and incorporate it in their investment selections?

Key to the experiment was conducting it during real-world conditions of the extreme market volatility caused by the COVID-19 pandemic.

“We talked about a research study like this and then waited for a market environment to see if people’s preferences were stable,” said Ryan Murphy, head of decision sciences at Morningstar.

As might have been expected, the four funds with five-year annualized performance above 8% were the most popular investment choices across all three groups of investors.

But access to sustainability scores and increased references to ESG investing presented to Groups 2 and 3 coincided with an outsized preference for a lower-performing fund that ranked high on the sustainability scorecard.

The Royce Special Equity Fund (RYSEX), which had a five-year annualized return of 2.3% at the time of the study, but a top-level five-globe sustainability rating, received an average allocation of 8% from Group 3 participants, 6% from Group 2, and less than 3% from Group 1.

The bottom line, according to Lamas and Murphy, is that an increased focus on non-financial factors such as ESG leads to investment decisions that are less correlated to past performance, which is a goal of most investment advisers when dealing with clients.

There is, however, the downside potential of the added ESG information leading to under-diversified portfolios, which might be among the reasons regulators have been reluctant to swing open the doors to ESG funds inside company-sponsored retirement plans.

History shows that when feeling overwhelmed by too much information, investors will revert to what seems easiest. The report assumes this was the case with some investors from the group receiving the most information who put all their assets into a single fund.

“This could be an example of choice overload where people feel overwhelmed by options and information and therefore resort to simple rules of thumb,” the report states. “This might be a useful heuristic when picking a meal from a multipage menu, but in the context of investing, under-diversification can hurt a portfolio.”