Investment professionals have been grappling with this question in recent years, driven by the continued proliferation of ESG-focused strategies, and particularly after the COVID-19-induced market pullback in March 2020.
Research conducted by Morningstar in the months following the drawdown concluded that there didn’t appear to be a performance trade-off associated with sustainable funds, and a majority of these funds actually outperformed their traditional peers over multiple time horizons, including holding up better during the sell-off.1
Many reasons for this empirical relationship have been suggested, ranging from better downside risk protection to more long-term thematic arguments. Research conducted by MSCI, using its proprietary ESG ratings, suggests that there are three major channels from ESG to financial value:
- Higher profitability (cash flow channel)
- Lower tail risk (idiosyncratic risk channel)
- Lower systematic risk (valuation channel)2
Despite this research, however, voices from the other side of the debate continue to be heard, especially in 2021, which has seen ESG underperform in periods. Where the market narrative was dominated by the so called “re-opening trade,” in which more cyclical and defensive names outperformed, ESG funds have lagged. While this has been sporadic, it has led some to question the outperformance of ESG over a full market cycle, and whether it can keep pace going forward.
There may be some validity to this argument. While the first iteration of ESG strategies—the funds that have been around the longest—outperformed the broader market, this may be because they typically tilted toward higher quality, growth companies as a result of their ESG scoring. The argument says that the performance could largely be replicated via a quality, growth strategy without ESG. Additionally, as ESG factors continue to be integrated into portfolios, any market inefficiency surrounding them will erode—and the first mover advantage of some of these funds may be eroded.
Looking ahead, we believe it is more likely for outperformance coming from activism and engagement to drive an increase in quality in a company along the lines of ESG factors. This is understandable as these factors— giving companies higher quality which should help them outgrow their competitors—should likely lead to higher valuation multiples.
1. Morningstar: https://www.morningstar.com/content/dam/marketing/emea/shared/guides/ESG_Fund_Performance_2020.pdf, accessed August 1, 2021.
2. MSCI: https://www.msci.com/www/research-paper/deconstructing-esgratings/01921647796, accessed August 1, 2021.
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