Environmental, social and governance (ESG) investment has largely moved into the mainstream over the past few years. Inspired by the desire to do well, investors have been attracted to the return profile of competitive risk-ESG strategies.
“ESG Investing: Can You Have Your Cake and Eat It Too”, we’ve documented ESG’s optimal risk and return performance over the past 12 years. Now, instead of accepting evidence over the past few years as a proof statement for ESG investments, we go further and address three important questions:
- Has the recent market environment been favorable or unfavorable for ESG investors?
- Will this environment remain the same or will it change?
- How should ESG investors adapt to potential changes?
Features of ESG portfolios
What sets ESG portfolios apart from their broader market criteria? They show more positive ESG properties, obviously, but they have less value-based and less volatility.
Let’s look at some evidence. Morningstar lists a total of 12 ESG index funds that fall into the category of its large mix funds. These funds track various ESG indexes, but all of them invest in large and mid-cap high-ESG stocks and try to control the risk of tracking errors. Despite these efforts to track the risk of error, there is a clear sector allocation trend in this index due to their initial goal of providing exposure to positive ESG qualities.
The sectors overweight and underweight of the ESG index funds compared to a broader market criteria are shown in the following chart.D
ESG Sector Overweight and Underweight
This sector shows a trend away from allocation growth-based technology stocks and price-based financial and energy stocks. Each ESG fund was overweight in technology and underweight in energy, and this technology-centric focus has recently given rise to criticism.
But what about the low volatility of ESG portfolios measured by standard deviation compared to their underlying criteria? Data on the return and volatility of the S&P 500 ESG index are presented below. Although designed to match the risk and return profile of the S&P 500 index, the ESG index has produced higher returns at lower risk for the period ending March 31, 2020.
|Three year return||Three years of volatility||Five year return||Five years of volatility|
|S&P 500 ESG Index||6.18%||14.9%||7.33%||13.5%|
|S&P 500 Index||5.10%||15.2%||6.73%||13.7%|
These results are consistent with our previous research which showed that higher ESG portfolios had lower volatility than their lower ESG counterparts.
Recent investment environment
If ESG funds overweight growth-based and low volatile stocks, how have these stocks worked lately?
Growth in spending has been good. The data below shows how much the stocks of value over the last three- and five-year period ending March 31, 2020 have outperformed the growth stocks.
|Three years||Five years|
|Russell 1000 price index||9.7%||8.29%|
|Russell 1000 growth index||20.5%||14.63%|
So tilting away from price stocks has probably been a tailwind for ESG investors over the past few years. What exactly does that tailwind look like? The following two charts provide an outline. The first is the Sector Overweight and Overweight chart shown above. Below this is the relative performance of the sector in the last five years. This combination reveals how overweight technology and underweight energy stocks have benefited ESG funds.
ESG Sector Overweight and Underweight
Sector performance related to the market
To assess the impact of the second risk of the ESG fund – towards lower volatility – we compare the performance of Russell’s stability index. The Russell 1000 Defensive Index measures the performance of more stable Russell 1000 companies, the Russell 1000 Dynamic Index which is less stable.
How have these two schedules worked over the last three- and five-year period ending March 1, 2020?
|Three years||Five years|
|Russell 1000 Defensive Indicator||16.3%||12.2%|
|Russell 1000 Dynamic Index||13.7%||10.7%|
These numbers indicate that risk towards less volatile stocks is also probably a tail for ESG investors.
Looking to the future
If both Tilt ESGs have worked well for investors in recent years, the next logical question is, what can we expect in the future? To answer this, we looked at the long-term history of price vs. growth and defensive vs. dynamic stocks. The long-term performance of this style indicator since rolling on a five-year basis is presented below.
Value increases on stock performance, rolling five-year average
Defensive on dynamic stock performance, rolling five-year average
The message is clear: Value’s recent weakness was not ideal in the long run. And the outperformance of defensive stocks follows a cyclical pattern compared to dynamic stocks.
This information leads us to suspect that the tails that have empowered ESG investors over the past few years are of a secular nature. They are circular. This means that going back to money will turn them into headwinds.
So what does an ESG investor do?
Indexed ESG investors have little choice but to stay within the framework created by these indicators. The underlying tilt in their portfolio will be hard to reverse.
But active ESG investors have a choice, and could work to address the impact of potential headwinds. The graphic below shows how they can accomplish this. In the first circle, the stock universe is divided into two equal parts, value and increment. In the second circle, the stock universe is arranged in two unequal divisions, favorable and unfavorable ESG stocks.
The ratio of favorable ESG stocks is larger than that of unfavorable parties because in practice most ESG investors – and ESG index funds – adopt the same policy. Only a minority stock is generally considered unacceptable from an ESG perspective.
Now, overlay the two graphs on top of each other. It creates four sections.
Stock by style and ESG features
Growth and high ESG are greater than cohort value and high ESG. This reflects what ESG investors have received so far: growth-based ESG stocks are easy to find; Price-based ESG stocks are not so high.
Looking ahead, active ESG investors should keep an eye on the price and high ESG segments. These stocks can help maintain high ESG qualities when preparing for the time when the style changes from tilewind to headwind.
Investors can apply the same logic to eliminate the potential negative effects of holding defensive stocks for too long. Look only for less protective stocks with positive ESG properties.
The normal trend of ESG is to lean towards growth and high quality thoughtful ESG investors should take a break. If the recent tailwinds are reversed, logically we need to look for ESG gems in two categories: standard and less defensive.
1. The Russell 1000 index is used here as a benchmark to represent large and mid-cap U.S. stocks. Sector allocations were found from the 31 December 2019 fact sheet published on the website of each fund. The two funds did not use the GICS sector classification and could not be included in this graphic; However, both funds show an extra weight for technology stocks and less weight than energy stocks.
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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed must not reflect the views of the CFA Institute or the author’s employer.
Photo Credit: © Getty Images / Pavliha
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