In these trying times, some dismiss sustainable investing as a luxury, several rungs below securing retirement savings on investors’ hierarchy of needs. In fact, the coronavirus crisis is yet another reminder that investing is impacted by a wide range of forces.
As argued in a recent The Wall Street Journal article, the crisis has also reinforced the importance of factors “paramount to ESG investors, [such as] disaster preparedness, continuity planning, and employee treatment through benefits.” There’s also the fact that incorporating environmental, social, and governance, or ESG, criteria into the investment process contributes to risk and return.
Earlier this year, Morningstar published a wealth of research on the nexus between ESG and risk. One study, “ESG Indexes Protect on the Downside,” concluded that 72% of Morningstar equity indexes that incorporate ESG screens lost less than the market during down periods for the five years through the end of 2019. It also found that the ESG indexes are more likely to select companies that are competitively advantaged and financially healthy, which undoubtedly contributed to their ability to reduce volatility.
Obviously, much has changed in markets since the end of 2019. The rapid, violent sell-off in first-quarter of 2020 offers an excellent follow-up opportunity to look at the performance of our ESG-screened indexes. We found that 51 of Morningstar’s 57 ESG-screened indexes, or 89%, outperformed their broad market equivalents in the first quarter of 2020. This is consistent with the conclusions that Morningstar director of sustainability research Jon Hale outlined in his article, “Sustainable Equity Funds Are Outperforming in the Bear Market.”
ESG Indexes Held Up Well in The First Quarter
Many funds and indexes incorporating ESG factors are fairly new. When we evaluated the risk characteristics of Morningstar’s ESG-screened indexes for the five years through the end of 2019, the worst stretch of performance they had endured was fourth-quarter 2018, when the Morningstar Global Markets Index lost nearly 13% of its value. Compare that to first-quarter 2020, when that broad equity benchmark declined more than 22%, entering bear market territory.
Other key points from our review of ESG performance in first-quarter 2020 include:
- Twenty of the 21 members of the Morningstar Sustainability Index Family, which is methodologically aligned with the Morningstar Sustainability Rating for funds, lost less than their broad market equivalent. For example, the Morningstar Global Markets Sustainability Index fell roughly 20%, while the Morningstar U.S. Sustainability Index lost 18.6%, more than two percentage points better than the broad U.S. equity market. That the margins are tight is by design. These indexes are constrained in their sector and regional weights to offer broad market exposure.
- The margins of outperformance widened for some less-constrained indexes. For instance, the Morningstar Global Markets Sustainability Leaders Index, which applies more stringent ESG criteria, lost 17%. The U.S. Sustainability Leaders Index declined 15.4%.
- All 10 members of the Morningstar Low Carbon Risk Index Family, which is methodologically aligned with the Morningstar Low Carbon designation, lost less than the market. So did the 10 members of the Morningstar Sustainable Environment Index Family.
ESG Indexes’ Performance is About Quality and Financial Health
There’s a temptation to dismiss the outperformance of ESG in first-quarter 2020 as a consequence of fortunate sector bets. Indeed, energy, a consistent underweight for ESG indexes, was the worst-performing sector thanks to an oil price war and falling demand.
But energy is a small portion of overall equity market value, and performance attribution analysis shows that while sector positioning helped, the resilience of Morningstar’s ESG indexes owed more to individual security selection. Consider:
- For the Global Markets Sustainability Index and the U.S. Sustainability Index, heavier weight to Microsoft (MSFT) and Visa (V) contributed.
- In Asia, above-market exposure to Alibaba (BABA), AIA (AAGIY), and NTT DOCOMO (DCMYY) boosted the ESG indexes.
- In Europe, heavier weight to companies such as Novo Nordisk (NVO) and Air Liquide (AIQUY) helped, as did below-market exposure to Airbus (EADSF) and Lloyds Banking Group (LLDTF).
The key to the story here is the relationship between strong ESG scores and attributes like quality and financial health. As explained in “The Highest-Quality U.S. Companies Have Weathered the Storm Best,” companies deemed by Morningstar equity research to have wide economic moats, or sustainable competitive advantages, tend to preserve capital best during downturns.
Analysis using the Morningstar Global Risk Model consistently shows that investments screened for ESG also score higher on measures like economic moat and financial health. Morningstar’s ESG indexes display these attributes, which engender durability.
ESG As a Risk Factor
As investors of all kinds increasingly think about ESG factors as risk factors, the relative resilience of Morningstar’s ESG-screened indexes in first-quarter 2020 offers a proof point that ESG investing is not just about values.
Far from a luxury best suited to bull markets, these factors materially impact company’s financial results and investor portfolios.
Dan Lefkovitz is a strategist for Morningstar's Indexes product group.