What the last few years taught us about ESG & market volatility
What the last few years taught us about ESG & market volatility
The United States has faced a worldwide health pandemic, the Black Lives Matter movement, the "Great Resignation," Capitol riots, and a slew of dramatic weather events, including drought, devastating tornadoes, flooding, and heatwaves, over the past two years. These upheavals have been accompanied by a volatile stock market and investors who moved record sums of money into ESG (Environmental, Social, Governance) funds.
One rationale, according to several studies, is that ESG investments can act as a buffer in portfolios, protecting them from stock market falls and volatility. ESG funds, for example, were more resilient than other funds during the late-2018 stock market collapse. Then came the spread of COVID-19 and some of the most volatile stock market conditions ever seen. However, studies show that during the March 2020 market downturn, many ESG funds outperformed equivalent non-ESG funds in terms of returns.
Some of this outperformance can be attributed to the fact that ESG investment strategies take into account variables other than financial returns, such as a company's impact on climate change, human rights violations in supply chains, executive compensation, and customer data privacy.
Because of its complex nature, the Covid-19 pandemic provided a prime opportunity to measure ESG funds against broad-market counterparts. Spoiler alert: numerous studies comparing ESG fund returns to the entire market during the volatility of 2020 found sustainable funds outperformed regular peer funds, reduced investment risk, and were more shock resistant.
The rise of ESG
Until the mid-2010s, few investors were concerned with ESG issues such as a company's carbon footprint, labor regulations, and board composition. However, due in part to the COVID-19 outbreak and green recovery in the United States, investors are increasingly choosing ESG funds over non-ESG funds to help assess a new set of financial risks and leverage capital market opportunities.
In 2021, $120 billion poured into sustainable investments, more than doubling the $51.1 billion invested in ESG funds in 2020 and setting a new annual record. And it looks like the upward trend will continue. According to Bloomberg, global ESG assets are on track to exceed $53 trillion by 2025, representing more than a third of the $140.5 trillion in projected total assets under management.
Investors utilize ESG investment strategies for a variety of reasons, including screening out poor and high performers, uncovering ethical issues, and urging companies to adopt sustainable practices using ESG data. Incorporating ESG into a portfolio or business can add a wealth of company value. Here are some of the advantages:
- Operating under an ESG framework can help organizations minimize environmental, social, and operational risks, as well as mitigate unfavorable government action to ensure long-term success.
- ESG tactics have been shown to have a major impact on consumer preferences, and strong ESG policies have been found to contribute considerably to increased business investment, revenue, and sales growth.
- Businesses that use good ESG practices can provide long-term efficiencies to balance rising operating costs, cut capital expenses, and raise a company's value.
- Employee satisfaction and talent attraction were found to be higher in companies with strong ESG frameworks.
- By providing concrete, quantitative metrics of a company's sustainability and corporate social performance, ESG delivers value to all of its stakeholders, including the financial return that shareholders desire.
Another compelling argument is the short- and long-term downside protection these funds provide, as well as their ability to mitigate risks such as climate change and market volatility.
ESG funds weather downturns better than peers, studies show
During the pandemic, the market saw dramatic swings, which were followed by a global recession and months of extreme market volatility, culminating in rising markets. According to the Morgan Stanley Institute for Sustainable Investing, ESG funds in both stocks and bonds fared better than non-ESG portfolios during the turbulence.
Sustainable equity funds beat typical peer funds by 4.3 percentage points in 2020, according to the research of more than 3,000 U.S. mutual funds and exchange-traded funds (ETFs). Study results also found that in 2020:
- Sustainable bond funds in the U.S. outperformed typical bond funds by 0.9 percentage points on average.
- The median downside deviation of sustainable equity funds in the U.S. was 3.1 percentage points lower than that of typical peer funds.
- The median downside deviation of U.S. sustainable taxable bond funds was 0.4 percentage points lower than traditional peer funds.
Many funds investing in companies with relatively high ESG ratings "appear to be more buoyant" than comparable non-ESG funds amid market falls, according to Morningstar research from 2020.
Morningstar looked at more than 137 funds with $50 million or more in assets across one, three, and five years through March 31, 2020, capturing some but not nearly all of the market volatility during the COVID-19 epidemic.
During significant market dips, ESG funds tended to capture less of the downside of their Morningstar benchmark and experienced less volatility than comparable non-ESG funds. Furthermore, funds with higher Morningstar sustainability ratings beat those with lower sustainability ratings within the ESG fund category.
MSCI compared the performance of four ESG indexes to the parent index, the MSCI ACWI Index, which is a comprehensive measure of equity-market performance that includes equities from 23 developed and 24 emerging markets. Overall, the results show that many ESG indexes fared better, despite the fact that volatility and downturn were still present.
During the COVID-19 epidemic, all ESG funds beat the parent index in the short and medium run, according to the research. While the numbers are limited in breadth and represent a short-term perspective, they may show that ESG variables have a beneficial impact on performance.
More recent studies from Statista discovered that the S&P 500 ESG index outperformed the normal S&P 500 index by roughly 3.7% over the three years leading up to October 2021. The economic repercussions of the COVID-19 pandemic, however, may account for the better profitability of sustainable investing. One of the most significant distinctions between the two indexes is that the S&P 500 ESG index has a higher concentration of technology stocks, which, until recently, was the best performing sector during the pandemic.
ESG strategies are winning strategies
Since the 2008 financial crisis, New Amsterdam Partners has been studying the relationship between ESG ratings and stock returns, volatility, and risk-adjusted returns. While the correlation between ESG rating and risk-adjusted returns has been negative in the past, they reported in their case study that the correlation between ESG rating and risk-adjusted returns has turned significantly positive in recent years, a shift that many expect to continue.
Overall, ESG policies ensure that businesses are better prepared to deal with dangers such as climate change and global pandemics. Investing in ESG-focused companies can help investors mitigate portfolio risk and guard against downside risk across both short and long time horizons. While the resilience and intuitive attractiveness of ESG investing have become more apparent, the evidence supporting these funds' forward-looking volatility prediction abilities proves to be similarly compelling.
ESG materiality assessments
With investors inquiring more and more frequently about what your company is doing in regard to responsible investment, how you treat employees and vendors, your dedication to sustainability initiatives, and other activities that fall under the ESG umbrella, it’s important to have answers to these questions.
An ESG materiality assessment empowers you to easily report on your current state and outline future initiatives while taking into consideration your business goals and risks. Download our guide to creating and extracting the maximum strategic value from an ESG materiality assessment.