Dan Kemp: Key driver of ESG funds’ recent outperformance was not ESG

Morningstar IM's Dan Kemp looks at recent dispersions in fund performance

Morningstar Investment Management’s Dan Kemp, CIO for EMEA and editorial panellist for ESG Clarity, looks at recent dispersions in performance of funds ranked high or low for ESG

Amidst the market turmoil of the last few weeks it is noticeable the prices of many high ESG funds held up better than their low ESG counterparts.

While many advocates of ESG investing have argued that high ESG companies should perform better, such fundamental differences tend to create dispersions in returns over the long term. In contrast, periods of market volatility are characterised by a shortening of investors’ time horizon and an increased focus on current over future risks. Therefore, while it is tempting to ignore what we know about the behaviour of investors and simply declare victory for the ESG approach, it is important to remember one of the foundational lessons of statistics: correlation does not imply causation. While high ESG funds performed better, it may not be due to their ‘ESG-ness’ but rather another factor.

With this in mind, we examined the returns of high ESG and low ESG businesses over the quarter by dividing each sector into ESG quartiles using Morningstar’s Sustainability Rating. By comparing the top and bottom quartiles we can see that there is no consistent difference between high and low ESG businesses at a sector level.

While high ESG companies in basic materials performed better than low ESG companies, the situation was reversed for energy and communication services.

The ESG characteristics of businesses was therefore not a key driver of funds returns over the period. Having said this, we do see a significant difference when we compare the performance of high ESG sectors to low ESG sectors. The former tends to be over-represented in ESG funds versus the latter and therefore, this dispersion in returns of these industries has been a key driver of relative performance over the quarter.

While some may argue that this industry dispersion is simply another expression of ‘ESG-ness’, we can see by examining which industries performed best and worst over the quarter that the dispersion in returns is can be traced primarily to the differing impact of covid-19 and disagreements within OPEC-Plus rather than ESG characteristics of the industry. For example, by avoiding energy and having a high exposure to healthcare, ESG fund have benefitted from shorter term economic changes rather than longer-term sustainability benefits.

This provides an important reminder for ESG investors that the assets they are purchasing are not just more sustainable than those that comprise conventional portfolios, but have different economic characteristics and hence valuations. As medium-term returns are typically dominated by valuation changes, it is essential that the asset allocation models used by ESG portfolio managers reflect the valuations of the assets they hold rather than those that dominate the conventional indices. Investors in our ESG portfolios have benefitted from this situation as our portfolios have a structural underweight to the energy sector.

Our portfolios also benefited from being somewhat defensively positioned due to our concerns about valuations. This has enabled us to look for opportunities in the current environment. However, following the recent price changes, we believe that the expected returns for high ESG UK sectors appear less attractive than low ESG UK sectors when viewed through a long-term, valuation-driven lens.

The implication for ESG investors is twofold: first, that conventional portfolios may deliver higher returns than ESG portfolios over the medium term. This may pose a challenge for investors that are less committed to ESG investing and so, presents an important suitability point for advisers as interest in ESG investing grows. Second, a less attractive risk-adjusted return for high ESG companies suggests that ESG portfolios should be taking a little less risk than conventional portfolios.

The current climate provides us with a timely reminder that while it would be wrong to declare victory for ESG following a period of sharp outperformance, it would equally be wrong to declare defeat when that situation is reversed.

Rather than seeking causation in the correlation of past returns, we should be focused on the path ahead of us and the opportunities to both deliver returns and support a more sustainable future.


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...