The first quarter of 2020 marked the end of an 11-year bull market and was characterized by volatility. While the entire market has been rocked by the pandemic, it appears that sustainable funds based on environmental, social and governance — or ESG — ratings proved relatively stable over the first quarter of 2020.
The sustainable funds weathered the changes relatively well compared to their traditional counterparts. According to data from Morningstar, 10 out of 12 sustainable funds found in the large-blend category — selected to reflect the overall market — lost less over the first quarter of 2020 than iShares Core S&P 500 Exchange Traded Fund, which also reflects patterns in the overall market. Jon Hale, global head of sustainable research for Morningstar, writes sustainable funds suffered sudden and large losses, but held up better than conventional funds.
ESG investing is a strategy for evaluating companies based on criteria related to environmental, social and governance factors in addition to traditional financials. The ESG approach to evaluating a company would look at environmental factors, such as how much or little the company pollutes, how it uses energy usage and its climate change potential. The social factors relate to business relationships including working conditions and relations with other stakeholders like suppliers. Governance refers to corporate governance: a company’s leadership, including executive pay, shareholder rights and transparency.
ESG evaluations ask both if the company's doing well and if it's doing good. There’s a difference: Many companies do well financially, but not all do good for the environment, for their employees and for shareholders. How high is the top executive being paid compared to the lowest-salary employee? What's this company doing to support their employees and shareholders, and how well-equipped is this company to face the effects of climate change? These are all questions that ESG evaluations ask.
Companies themselves and CEOs also use ESG criteria as a tool to evaluate their own performance. Many companies including JP Morgan Chase and Goldman Sachs have released their own reports of ESG criteria on their performance over ESG factors; however, different firms use different ESG criteria.
ESG has already gained some degree of ubiquity in the market long before the pandemic. According to a 2018 report by the U.S. Sustainable Investment Forum, assets under professional management using socially responsible investment strategies grew from $8.7 trillion in 2016 to $12 trillion at the start of 2018. This number represents 26% of the $46.6 trillion in total U.S. assets under professional management. According to a 2018 global survey by FTSE Russell, 53% of survey respondents or “asset owners” responded that their organization is currently implementing or evaluating ESG considerations in their investment strategy.
ESG is also popular among millennials. According to a survey by Nuveen which asked about investor interest in responsible investing, 92% of millennial investors would place all of their assets in a sustainable investing portfolio compared to 52% of investors overall who felt the same way.
Why are ESG funds performing relatively well amid the COVID-19 crisis? According to Hale, part of the reason sustainable funds did well in the first quarter is that they're relatively underweight in the energy sector. They don’t contain as many energy stocks, so when oil prices plummeted during the first quarter, the sustainable funds were less impacted by losses from energy stocks.
Brian Menickella wrote for Forbes “investors need a way to price in risk, and as of April 2020, there are simply too many unknowns surrounding COVID-19 for investors to predict the economic impact, leading to fear and extreme volatility.” The ESG framework is useful for investing in volatile situations like the bear market brought on by COVID-19 because ESG focuses on the quality of the company: how well the company is run, how they manage resource use and how they treat their employees and stakeholders.
The volatility also forces companies to pay more attention to their ESG profiles. According to an analysis by S&P Global, “With the unprecedented disruption being wrought by this pandemic, companies across the globe will be forced to closely manage their social and human capital and scrutinize their strategies as well as their readiness for ‘black swan’ type risks.”
Hester Peirce, head of the Securities and Exchange Commission, has criticized ESG for a lack of clear reporting standards. In a speech at the 2018 SEC Conference, Peirce argued, “companies are at the mercy of the standard setters, whose approaches to collecting and analyzing information differ.” Many different organizations, including the Global Reporting Initiative, the Sustainability Accounting Standards Board, the Task Force on Climate-Related Financial Disclosures and the CDP, have developed different reporting standards for companies to use, resulting in a lack of standardization.
According to Peirce, the problem with ESG criteria as a part of pension funds’ decision-making is that pensioners can’t leave their fund. Peirce argues that it's too easy for funds to reflect the individual morality of a money manager which may not be in the financial interest of the pensioner.
In addition to the volatility brought on by the COVID-19 pandemic, climate change is an ESG-related issue that is gaining importance for businesses to address.
According to a 2018 report from US SIF, climate change was the most important specific ESG issue considered by money managers in “asset-weighted terms.” The assets to which the criterion applies more than doubled from 2016 to 2018 to $3.0 trillion in value.
As climate change becomes a more concrete issue, and if more pandemics happen, companies who adhere to good ESG principles — preparedness with contingency plans, better governance, better ways to help their employees and more environmental stewardship — are better equipped to deal with the changes brought on by the virus and climate change.
Jillian Lynch is a senior international affairs major. Contact Jillian at email@example.com.
Disclaimer: I/we have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I’m not receiving compensation for it, and I have no business relationship with any company whose stock is mentioned in this article.