Does ESG investing deliver its promise?
Latest data show that ESG funds have significantly lower downside risks
RELIABLE fund managers and investment strategies should be able to perform even through a significant market downturn. With the broad market sell-off in the past week sending worrying signals arising from the coronavirus pandemic, now is the perfect time to verify if environmental, social and governance (ESG) investing can outperform in a down market.
Drawing from the latest data available on Morningstar, there are indications that ESG investing can offer protection against downside risks. The effect is most apparent in the fixed income funds. But there are also indications that relying on ESG investing alone may not necessarily outperform and generate alpha.
Chart. 1: Average rate of return of the 10 worst performing ESG and conventional funds (equity and fixed income) on an annual basis (source: Morningstar, data as of March 13 2020)
To make a fair comparison, we compare the ten worst performing ESG funds to their conventional counterparts to see if ESG investing offers protection against downside risks. The period covered is March 2019 to March 2020. The result is positive.
According to chart 1, ESG focused equity funds suffered losses of less than 40% on average, while, conventional equity funds could incur as much as 80% losses in terms of annualized return.
The difference is even more pronounced in fixed income where ESG funds incurred an average loss of only 2.92%, technically remaining intact. The conventional fixed income funds, on the other hand, incurred losses of as much as negative 32.91%.
However, the other side of the coin suggests that ESG investing alone would not necessarily outperform conventional strategies.
Chart. 2 Average rate of return of the 10 best performing ESG and conventional funds (equity and fixed income) on an annual basis (source: Morningstar, data as of March 13 2020)
The ten best performing ESG funds were compared to traditional funds. The result in chart 2 shows that conventional funds on average deliver a higher annualized rate of return even in a time of crisis.
The conventional equity fund generated a 42.93% rate of annual return on average while the ESG funds only delivered 26.91% annual return. A similar pattern appears in the fixed income funds with conventional funds outperforming ESG funds.
However, in some cases ESG investing can generate as much alpha as conventional strategies. Among the 10 best performing ESG equity funds, two funds actually produce a comparable level of annual return (43.45% and 43.07%) to traditional funds. Similarly, another ESG fixed income fund was able to deliver 43.07% of annualized return, as good as the conventional fixed income funds.
The data are drawn from the fund screener of Morningstar database.
At first, equity funds and fixed income funds are ranked separately according to their one-year annualized rate of return. The rate of returns of the top 10 performing funds in each category are averaged to produce Chart 2. The bottom 10 funds’ rate of returns are averaged to produce Chart 1.
To compare ESG strategy with conventional strategy, we use Morningstar’s own sustainability ratings, which draws data from Sustainalytics, as the differentiator. Funds receiving “5 globes” rating would be considered as an ESG fund. And similarly, the rate of returns of the top 10 performing ESG funds are averaged to produce Chart 2. The bottom 10 ESG funds’ rate of returns are averaged to produce Chart 1.
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