For those that don’t know, the ESG in ESG Investing stands for:
The history of using nonfinancial factors to invest has changed rapidly over the last few years. Socially responsible investing has been around for decades. Investors have been screening out companies that go against their values, like oil, tobacco, or firearms for years. The items that are screened has grown to include many more things, like diversity and climate change.
ESG (sometimes called Impact) Investing has gone mainstream in part due to the “doing well by doing good” mindset, like you see with Love Your Melon beanies (my millennial sister loves those hats!). It has also become more and more accepted that some of the doing good criteria may also lead to better long-term risk-adjusted performance – that doing good causes good returns.
This belief was reinforced by the outperformance of ESG indices and funds during the recent COVID-related downturn. As of May 8, 2020, the year-to-date performance of a major ESG index and the S&P 500 (the normal “market”) is listed below and as you can see, the ESG index weathered the COVID storm a lot better than its peer.
(from the S&P 500 Dow Jones Indices)
But as a recent CFA (Chartered Financial Analyst) article points out, you have to make sure you draw a distinction between correlation and causation. https://blogs.cfainstitute.org/investor/2020/05/05/headwinds-approaching-are-esg-investors-prepared/?s_cid=olm_MemberApp
When temperatures rise each summer, both the sale of ice cream and the murder rate often go up. Ice cream and murder might be correlated (going up and down together), but ice cream is not the cause of the increased killing. The increase in temperature is the cause for both outcomes. If ice cream were the cause of murder, Cabot Cove might outlaw Rocky Road, putting Jessica Fletcher from Murder She Wrote out of business.
When looking at the return and volatility of many of the ESG funds, you would say “wow, doing good does mean doing well”. I would love it if companies that do good are rewarded with better performance both in the real economy and the financial markets, but as the CFA article points out the ESG indices have a substantial overweight (more exposure) to Growth tech-type stocks and an underweight (less exposure) to energy and financial Value stocks.
ESG Sector Overweights and Underweights
Even those that are new to investing, or indifferent, know that many Growth-type tech companies have prospered as we are all working from home more. Growth companies have also outperformed over the last 10+ years most likely due to low rates, low inflation, and increased innovation. It is tough to deny that ESG factors were correlated with better performance, but not the cause.
Whether it’s investing, or anything else, we all tend to believe that to do good requires sacrifice. And when it comes to investing, historically, that has meant sacrificing returns, or at least risk-adjusted returns, but that may be changing. There may be a paradigm shift in the works that may not only mean no sacrifice, but that ESG factors lead to excess returns – a reward. But that reward did not happen during COVID. I hope that if well-intentioned investors get caught on the other side of the Growth-Value trade, it does not turn them off to the long-term potential of ESG investing.