Investors are increasingly focused on the connection between environmental, social, and governance (ESG) factors and risk. From company-specific blowups like the ones at BP (BP), Volkswagen (VLKPF), Toshiba (TOSBF), and Equifax (EFX) to the systemic threat of climate change, ESG-related issues can materially impact a company’s financial results.
Unsurprisingly, investors of all kinds are integrating ESG analysis into their decision-making calculus. But do ESG screens actually lower risk?
One way to answer that question is to look at the behavior of Morningstar’s lineup of ESG-screened indexes. Because these indexes tend to be constrained in their sector and regional weights, they can help determine whether companies that score well on ESG are also more resilient.
Our study, “Morningstar’s ESG-Screened Indexes Protect on the Downside,” shows that Morningstar’s ESG indexes have lost less than the market during down periods. Not only have the indexes preserved capital in stress tests like the fourth quarter of 2018, but they tend to favor companies that are financially healthy and well-positioned competitively.
Testing Morningstar ESG Indexes for Risk
To test the risk levels of Morningstar’s 50+ ESG-screened indexes, we evaluated their five-year downside capture ratios through the end of 2019. As its name implies, downside capture gauges whether an investment has lost more or less than the market during down periods. Because losses are hard to recover from and investors tend to have weak stomachs, capital preservation through difficult periods is critical to long-term investment success.
The five-year period captures a good amount of live index history. The Morningstar Sustainability Index Family was launched in 2016; Sustainability Leaders, Sustainable Environment, Low Carbon Risk, and Morningstar’s three impact indexes were launched in 2018. The indexes have returns back-tested further using historical Sustainalytics ratings, which help investors evaluate how well a fund is managing its ESG risks. Crucially, most of these indexes were live during the most important stress test of the past five years—the fourth quarter of 2018, when global equities lost 13% of their value.
The study concludes:
- 72% of Morningstar’s ESG-screened indexes exhibited five-year downside capture ratios below 100, indicating they held up better than the overall market during down periods between 2015 and 2019.
- Morningstar’s ESG-screened indexes also scored higher on measures of financial health and sustainable competitive advantage than their equivalents, according to a Morningstar Global Risk Model analysis. 70% of the ESG indexes scored higher on the economic moat factor and 79% scored higher for financial health.
ESG and Risk: A Strengthening Relationship
Sustainable investing traces its origins to values-driven approaches that excluded certain types of securities on ethical grounds. Today, however, investors of all kinds integrate ESG analysis into their process. They believe that examining corporate behavior on matters such as energy efficiency, health and safety, and accounting standards will improve their investment selection and, ultimately, their risk/return profile.
The fact that Morningstar ESG-screened indexes have lower risk than their equivalents provides one proof point for the connection between sustainability and risk. The indexes will be even more risk aware going forward, as they transition to the Sustainalytics’ ESG Risk Rating for company-level assessments to match the evolution of the Morningstar Sustainability Rating for Funds.
Dan Lefkovitz is a strategist for Morningstar's Indexes product group.