ESG Doesn’t Thrive in Every Market Environment
Despite a subpar first quarter, the long-term case for ESG remains strong.
The first quarter of 2021 was a challenging one for the performance of investments screened on environmental, social, and governance criteria. Why? Equity market dynamics summarized in Morningstar’s first-quarter 2021 market summary help explain. As Katherine Lynch writes: “Laggard value stocks leapt to the lead, richly valued growth stocks faded, energy stocks bested all other sectors, and technology stocks landed in the unusual position of worst performers.” ESG screens tend to favor growth over value and technology over energy.
Reflecting ESG’s first-quarter struggles, Morningstar’s range of ESG-screened indexes generally underperformed their broad market equivalents in the first quarter, with some important exceptions. For sustainable investors, it’s an important reminder that any deviation from a broad market portfolio will inevitably go through cycles. Sustainable investments performed well as a group during the growth rally of recent years but will remain challenged if the carbon-intensive energy sector continues to lead the market.
How widespread was ESG’s underperformance? During the first quarter, just 24% of Morningstar’s ESG-screened indexes beat their broad market equivalents.
Long-term, though, the investment case for ESG is encouraging. That fact that ESG screens have led to resilience in recent down markets, driven by the relationship between sustainability and attributes like corporate quality and financial health, supports the view that ESG risk is material. The persistent perception that sustainable investing requires a return sacrifice is misplaced.
For years, the market’s preference for growth stocks has benefited sustainable investments. Technology-related companies have led global equity markets for more than a decade, while energy in particular has lagged. When company-level ESG Risk Ratings from Sustainalytics are aggregated to the sector level, technology and tech-related companies as a group carry far less ESG risk than energy, utilities, and basic materials, which tend toward the value side of the market. To name some examples, Microsoft (MSFT), Nvidia (NVDA), and Salesforce.com (CRM) are far more common constituents of ESG-screened portfolios than Exxon Mobil (XOM) and ConocoPhillips (COP).
Against this backdrop, our analysis of Morningstar’s ESG-screened indexes found that 52 of 69 (75%) bested their broad market equivalents in 2020, while 88% outperformed for the five years through the end of 2020. While these findings do include some back-tested index performance using historical Sustainalytics assessments, and exclude a few indexes that combine ESG with other factors such as dividends or valuation, the findings were broadly consistent with what Jon Hale and others have observed for intentionally sustainable funds.
But lately, the market’s rotation to value and the resurgence of the energy sector left ESG out of step. As Russel Kinnel observed, equity market leadership began to shift in September 2020. November saw an acceleration of the trend when COVID-19 vaccines and U.S. presidential election results lifted hopes of an end to the coronavirus pandemic and a stimulus-fueled recovery. But it wasn’t till the first quarter of 2021 that value stocks opened up a more significant lead.
For example, the Morningstar US Sustainability Leaders Index, which is concentrated, unconstrained, and maintains high ESG standards, returned roughly 3.9% for the first quarter compared with 4.8% for the large-cap equity segment from which it is drawn.
What drove those returns?
But to keep the first quarter trends in context, the US Sustainability Leaders Index averaged an 18% annual return for the three years through the end of 2020, while its equivalent market segment returned 15.7%. The biggest contributors to the outperformance were above-market technology exposure and below-market energy exposure.
This isn’t the first time a value rally has treated ESG unfavorably. In the fourth quarter of 2016, Donald Trump’s election victory was interpreted by the market as a boon for economically sensitive sectors that would benefit from spending, protectionism, and a regulatory rollback. Energy and basic materials soared. Only nine of the 21 members of Morningstar Sustainability Index Family, which was launched in mid-2016, outperformed during the value rally of 2016’s fourth quarter.
The full story of ESG in the first quarter contains nuance though, as is always the case. First, it must be pointed out that some ESG-screened indexes overcame challenging sector dynamics and outperformed regardless. The Morningstar US Sustainability Index is one prominent example. That index, which keeps its sector weights roughly in line with the market while emphasizing companies with lower ESG risk, posted a strong quarter thanks to the stocks it both included and excluded. Above-market exposure to Microsoft and Home Depot (HD), which had strong quarters, helped. Not including Amazon.com (AMZN), and Tesla (TSLA), both of which struggled, helped the ESG index.
Why aren’t Amazon.com, and Tesla especially, in the US Sustainability Index? Neither of them made the inclusion threshold based on Sustainalytics’ assessment of their ESG risk. Amazon.com falls short especially on the social side, while Tesla, among other things, is quite carbon-intensive in its operations even if its product is environmentally friendly.
To say that ESG is all about heavy technology and light energy is a caricature. There are plenty of technology and tech-related companies that don’t score well on ESG, while some companies within the energy, utilities, and materials sectors manage their ESG risk well. Our previous studies of ESG index performance observed that both sector biases and security selection contributed to strong performance.
Also, ESG is a broad tent, including a range of criteria. Two of Morningstar’s ESG-screened indexes that outperformed in the first quarter put more emphasis on social factors than environmental. The Morningstar Minority Empowerment Index and the Morningstar Women’s Empowerment Index employ diversity, equity, and inclusion screens and were actually heavier on energy and lighter on technology than the market. Technology companies, generally speaking, are not exemplars of gender and racial diversity. Some energy companies score well.
Ultimately, it’s key not to get too hung up on short-term performance fluctuations. No investment strategy works all of the time. ESG screens cause divergence from the market, which will inevitably lead to good performance in some environments and underperformance in others.
We have found that ESG screens have led to resilience in down markets, even in brutal downturns since as March 2020. Morningstar and Sustainalytics have documented links between ESG and factors like corporate quality and financial health. So long-term, there are reasons for investors to be encouraged about the prospects for ESG investments in their portfolios.
Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.
Dan Lefkovitz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.