Ethical investing in uncertain times: How safe are ESG funds?

Ethical investing in uncertain times: How safe are ESG funds?

 Spencer Kelly & Recha Bergstrom, MD

With the stock market falling and industry experts warning of a possible recession, investors may be worried about the safety of their investments. Individuals with money in environmental, social, and governance (ESG) funds may be especially concerned: socially-conscious investment vehicles have only become widely popular over the past decade, and have not yet been tested in an extended downturn.

Though the research is far from conclusive, some studies have indicated that ESG funds may actually be “safer” in uncertain times than traditional investments. Here we will go over the basics of ESG before reviewing some of the evidence for and against ESG funds as resilient investment vehicles.

 ESG Investing Explained

 Environmental, social, and governance (ESG) is a set of criteria that investors can use to screen for socially-conscious companies.

 Environmental criteria screen for a company’s impact on the natural world. This may include climate policies, energy or resource use, greenhouse gas emissions, and treatment of animals.

 Social criteria examine a company’s efforts in promoting social justice within and without their organization. Factors include internal LGBTQ+ policies, racial diversity, and hiring practices within the company but also advocacy for justice in the public sphere.

 Governance criteria focus specifically on company leadership: their actions, interactions, objectives, and accountability, among other factors.

 ESG scores for companies are calculated by research firms like Bloomberg, S&P, and Dow Jones. It is possible to invest in individual stocks with high ESG scores, but a more convenient option is to invest in mutual funds or exchange-traded funds (ETFs) that contain a basket of high-ESG scoring organizations. Some popular ESG funds include the Vanguard FTSE Social Index Fund (VFTAX) or iShares MSCI USG ETF (SUSA).

In its most nascent form, socially-conscious investing dates back to the 1970s. However, contemporary ESG criteria were not formalized until the 2006 United Nations “Principles for Responsible Investment” report.

Mainstream ESG investing has taken off since the mid-2010s. In 2016, ESG funds had $22.8 trillion in assets under management (AUM); the total was $30.6 trillion by 2018, and by 2020 there were $35 trillion in AUM. Bloomberg estimates that ESG assets will exceed $50 trillion by 2025, representing more than one third of total global AUM.

 ESG resilience: The supporting evidence

 Questions about the riskiness of ESG funds rose to prominence in the mid 2010s once these funds became increasingly popular investment options.

 Early studies were optimistic. A 2016 paper in the Journal of Sustainable Finance & Investment concluded that “our model shows evidence that stock performance is closely linked with ESG factors. ESG factors bring lower volatility and therefore lower risk, and consequently higher risk-adjusted returns.”

But since ESG investing only became a mainstream phenomenon during a decade of record stock growth, these funds had not been tested with a severe downturn or much volatility overall.

This changed in 2020 when the arrival of COVID-19 shocked the market. Financial analysts recognized that the pandemic was a pivotal test for ESG funds and “an inimitable opportunity to question if investors interpret ESG performance as a signal of future stock performance and/or risk mitigation.”

 In general, ESG not only passed the test, but excelled. A June 2020 study from the European Corporate Governance Institute found that “Stocks with higher ES ratings have significantly higher returns, lower return volatility, and higher operating profit margins during the first quarter of 2020.”

Building off these findings, an August 2020 paper similarly showed that “(i) high-ESG portfolios generally outperform low-ESG portfolios (ii) ESG performance mitigates financial risk during financial crisis and (iii) the role of ESG performance is attenuated in ‘normal’ times, confirming its incremental importance during crisis.”

A report from Morningstar confirmed ESG’s superior performance in 2020 but also determined that the resiliency of ESG investments dated back even further. The report concluded that “At a broad level, the story was consistent: In the past one-, three-, and five-year periods, ESG stock and allocation fund strategies lost less money than non-ESG funds during market declines and displayed less volatility. Among 11 Morningstar Categories, the average down capture for ESG funds through the year ended March 31 was nearly 12 percentage points better than category averages.”

In short, there is indeed some convincing evidence that ESG funds are safer or more resilient in economic crises than their non-ESG counterparts.

 ESG resilience: The opposing evidence

 However, other recent trends paint a less rosy picture for the resilience of ESG.

 In a tough 2022 for stocks, ESG performance has not replicated its 2020 success. According to Bloomberg, as of September just 3% of the 166 US-listed ESG funds had positive returns in 2022, compared to 9% of all US-listed stock funds.

ESG’s poor performance can in large part be attributed to its over-allocation in tech companies, which align with ESG criteria to a disproportionate extent. About 28.5% of assets in ESG funds are tech stocks, compared to 23% of all global funds.

Tech companies had dominated the markets over the past decade and drove the previously stellar performance of ESG. Now they are dragging ESG funds down. As of September 27, the Morningstar US Technology Index was down 24% over the past year, while the overall U.S. stock market has only dropped 19%. ESG funds’ over-allocation in tech stocks may mean that these funds are (at least for now) reliant on strong tech performance, something that is evidently not guaranteed.

 There are also fundamental concerns with ESG criteria. A 2020 BNY Mellon report found that, among institutional investors, “there is no agreed-upon definition of what ESG means.” Consequently, a company’s ESG rating can vary widely based on which investment firm is evaluating it.

 This has led to serious concerns about “greenwashing,” where companies erroneously represent themselves as ESG-aligned, taking advantage of the ambiguity surrounding ESG criteria. Investors can, therefore, be swindled into buying stock in a company that isn’t as ethical as they thought.

 But investment funds themselves are also guilty of greenwashing. An analysis by TrueMark Investments determined that “many ESG ETFs have a carbon footprint that is scarcely lower than the S&P 500” (an index containing the 500 largest US companies by market capitalization).

A study from EDHEC Business School in France found that, rather than basing investment decisions on socially-conscious criteria, ESG funds typically view market cap as the most important factor in deciding whether to include a company in their portfolio. Consequently, “the impact of market capitalisation [sic] overwhelms any climate consideration.” The study concluded that “when climate considerations represent less than 50% of the determinants of the weight of the stocks in [an ESG] portfolio…then this portfolio should be considered to be at a significant risk of greenwashing.”

The lack of ratings standards is an issue for the viability of ESG investing as a whole. But this is especially problematic for those who invest in ESG funds for their possible benefit of safety. An incorrectly rated or improperly included company may not weather economic storms to the degree expected, with potentially severe consequences for individual investors’ portfolios.

Conclusions and considerations

 In short, the evidence for whether ESG funds will be safer in a potential 2022 recession is inconclusive. However, perhaps such a short-term outlook should not matter for socially-focused investors.

 Fidelity portfolio manager Matt Egerton reminds ESG investors to take a long view with investment analysis. “In such an uncertain environment we think it is important to step back and look at some of the structural trends in the US market, one of which we think very clearly is sustainability…We believe investors should focus on durable themes centered around the world’s biggest long-term challenges, which can have remarkable staying power in the midst of geopolitical and economic volatility…These trends are very much intact despite the increasing noise of the global financial markets. Often, periods of crisis actually serve to accelerate sustainable changes that are already underway.”

Aimee Forsythe, portfolio manager at Cambridge Trust, provides a similar perspective: “ESG investing’s primary objective is not short-term, high risk or rapid growth; it’s a long-term, sustainable investing strategy that allows investors to achieve capital appreciation in alignment with their principles in environmental protection, social awareness and strong governance.”

So, the most important considerations for ESG investments should, for one, be long-term in nature, but also grounded in individual ethics. An ESG investment should be viewed not just in the context of your personal portfolio gains, but in the context of your personal values, and your potential impact on the world.