In a Tough Quarter, Sustainable Strategies Struggled But Stayed Competitive

There wasn’t much working in favor of sustainable investing strategies in the second quarter.

Technology stocks that are big holdings in many environmental, social, and governance strategies were clobbered. Microsoft MSFT and Nvidia NVDA, the largest two holdings in the Morningstar Sustainability Leaders Index, have fallen further than the rest of the market this year with losses of 16.5% and 44.4%.

Meanwhile, energy stocks that are an anathema for many sustainable investors continued their strong run. More broadly, value-stock focused strategies continued to do well, while sustainable investing, seen as having a growth-stock tilt thanks to heavier holdings of tech names, lagged. Despite that, sustainable equity strategies held up relatively well compared to the broader market, and in some cases even fared better.

Healthcare stocks, which benefited from investors seeking out safe havens from the market turmoil, were key to the buoyancy of many ESG strategies. Gilead Sciences GILD and Bristol-Myers Squibb BMY earned strong returns for the quarter and both score in the top 6% of the over 400 biotechnology companies with Sustainalytics' ESG Risk Ratings. Another group of defensive plays, consumer staples stocks, also helped sustainable strategies stay in the race.

And over the longer term, ESG-focused investing strategies of all kinds have come out ahead of the broader market.

But there’s no doubt, the market backdrop has not been friendly for sustainable investors. “Sustainable investing is facing strong headwinds right now,” says Todd Ahlsten, chief investment officer and lead portfolio manager at Parnassus Investments. Energy, oil, natural gas, mining, and defense sectors have all been relative winners, he notes.

“At the same time, some of the cutting edge, futuristic ESG-type investments have suffered,” Ahlsten says.

“But between all of that, there’s a lot of well-run, high-quality companies that are thinking about diversity, doing things to decarbonize, and running responsible businesses.”

During the second quarter, the Morningstar US Sustainability Index, which tracks the broader US equity market but screens out companies with the highest ESG risk, lost 15.9%, outperforming the Morningstar US Market Index, which fell 16.9%.

The picture wasn't as bright for the best-scoring sustainability stocks. The Morningstar US Sustainability Leaders Index, a collection of 50 U.S. large-cap stocks with the very best sustainability scores, lost 19.0% during the second quarter.

Globally and across markets, just five of the 21 Morningstar standard sustainability indexes, broad-market indexes for the respective regions with overlays that screen out companies with higher ESG risk ratings, outperformed their broader market benchmarks during the second quarter. Over the past five years, 15 of the 21 indexes beat their benchmarks.

For the U.S.-based sustainable investing strategies, nine of 12 outperformed or fell in line with the Morningstar US Market Index during the second quarter. The Morningstar US Sustainability Leaders Index was hardest hit, while the value-leaning Morningstar US Sustainability Dividend Yield Focus Index topped the group in both the second quarter and the year to date.

For the past five years, the Morningstar US Sustainability Leaders Index gained 76.3%, while the standard Morningstar US Sustainability Index trailed advanced 69.6%. Both edged out the broader equity market, which rose 67.7% as measured by the Morningstar US Market Index.

What Kept Sustainable Investing Strategies Competitive in Q2?

The Morningstar Sustainability Dividend Yield Focus Index, a value-leaning ESG index, was the top performer among Morningstar’s U.S. sustainability indexes for the quarter. Companies in the index are all high-yielding, qualified-dividend-paying businesses with relatively strong balance sheets that score well on ESG investing criteria.

For the second quarter, the companies that helped the index came primarily from the consumer defensive and healthcare sectors. Pharmaceutical manufacturers and non-alcoholic beverage company stocks made the biggest contributions.

On the opposite side of the spectrum, the Morningstar Sustainability Leaders Index, which has a stronger growth bias than the Morningstar US Market Index, was dragged down by technology stocks in the software, semiconductors, and consumer electronics industries.

The energy sector, which sustainable investing strategies largely stay away from, has been the year’s high flyer. The Morningstar US Energy Sector Index rose 30.2% in the first half, while all other U.S. sector indexes lost ground. Yet, Morningstar’s U.S.-based broad sustainability indexes averaged losses of 15.7% for the quarter, neck and neck with the overall equity market.

“Energy had shrunk to such a small percentage of the overall market leading up to this year,” says Paul Arnold, portfolio manager and co-head of asset allocation strategies at Morningstar Investment Management. “So now, when energy stocks outperform, it's a much smaller percentage of the total market index that's outperforming, and it doesn't have as big an impact on ESG performance.”

At the start of the year, the energy sector made up 3.3% of the Morningstar U.S. Market Index. Ten years ago, that number was 10.2%.

What Do the Current Struggles Mean for the Long-Term Performance of Sustainable Investing?

The ability of sustainable investing strategies to remain competitive in a quarter when value outperformed growth runs counter to the common perception of a heavy tilt toward growth stocks among ESG strategies.

"Sustainable investing can have a growth bias, but many basic (ESG) screening strategies are essentially not that different from the broader market, growth- and value-wise," Arnold says. "They track their broader market index closely." That's part of why even as growth stocks tumbled, many sustainable investing strategies stayed afloat. Even so, ESG is "a specific style of investing," Arnold says. "By definition, there are going to be times when it outperforms and times when it underperforms, as does any strategy."

“It just so happens that we had a really great five-year stretch for investors that focused on sustainability. But over the past six months, we’ve been in a period where that is not the case,” Arnold says. “Anybody that didn’t think this was going to happen was lying to themselves or misleading investors.”

“Stocks move for all sorts of reasons,” Ahlsten says. “One ESG factor will not be able to lead to outperformance. But if you focus on high-quality companies, especially in downturns, those can bear fruit over time and outperform in the long run.”

“Sustainable investing trends remain unabated,” Ahlsten says. “The strongest businesses are still working to decarbonize the globe, improve hiring practices for diversity, and innovate for the climate. These forces provide a long-term secular tailwind for sustainable investing.”