Portfolios With Low ESG Risk Outperform in Times of Crisis

This
suggests
that
while
investment
in
targeted
ESG
efforts
is
receding,
investors
still
like
to
park
assets
in
funds
that
exclude
high-risk
securities. 

Morningstar
Sustainalytics
partnered
with
Natixis
Investment
Managers
Solutions
on
an
analysis
of
return-
and
risk-related
behaviour
of
assets
with
different ESG
Risk
Ratings.
They
found
portfolios
with
low
ESG
risk
typically
display
better
raw
and
risk-adjusted
returns
than
portfolios
with
high
ESG
risk—and
they
have
a
better
ability
to
withstand
financial
crises.

ESG
Offers
Downside
Protection
During
Market
Crises

Sustainalytics
used

Morningstar
Direct‘s
scenario
analysis
tool
to
run
a
series
of
stress
tests
on
ESG-constructed
portfolios
during
three
past
crises:
the
2007-09
subprime
crisis,
the
2010
Greek
crisis,
and
the
2011
US
debt
ceiling
crisis.
In
all
regions
and
for
all
three
scenarios,
the
lower
ESG
risk
portfolios
had
better
return
performance.

This
is
likely
because
the
factors
common
to
the
lower
ESG
risk
portfolios
regarding
volatility,
financial
health,
valuation
uncertainty,
and
economic
moat
generate
downside
protection
under
these
more
negative
economic
scenarios—suggesting
that
low
ESG
risk
portfolios
have
a
better
ability
to
withstand
financial
crises.

Low
ESG
Risk
Generates
Better
Risk-Adjusted
Performance
in
the
Long
Run

Averaging
returns
over
the
period
examined
(December
2014–April
2023),
the
findings
show
that
lower
ESG
risk
portfolios
outperform
their
respective
regional
high
ESG
risk
portfolios
in
all
three
regions
on
returns.

Average
annualized
returns
across
regions

To
take
a
closer
look
at
these
returns
by
region:

• 
  Europe has
  been
  the
  most
  consistently
  outperforming
  region
  for
  low
  ESG
  risk
  portfolios
  since
  January
  2015.
  The
  spread
  between
  the
  low
  and
  high
  ESG
  risk
  portfolios
  continued
  a
  daily
  year-over-year
  expansion
  for
  nearly
  five
  years
  straight,
  apart
  from
  a
  slight
  decline
  between
  November
  2016
  and
  January
  2017.
• In North
  America, the
  two
  portfolios
  appear
  to
  trade
  very
  closely
  in
  line
  with
  one
  another.
  Significant
  outperformance
  for
  the
  low
  ESG
  risk
  portfolio
  occurred
  when
  the
  market
  declined
  in
  2015,
  but
  the
  gap
  narrowed
  shortly
  thereafter
  and
  even
  turned
  negative
  for
  a
  period
  as
  the
  market
  rose
  in
  2018.
• For
  the Asia-Pacific
  region,
  the
  ESG
  risk
  premium
  was
  strong
  in
  2015,
  allowing
  it
  to
  continue
  compounding
  returns
  into
  other
  years.
  Much
  like
  Europe,
  the
  strategy
  slowed
  from
  December
  2017
  to
  January
  2018
  but
  regained
  momentum
  until
  the
  covid-19
  selloff
  rebound
  in
  March
  2020.

Interestingly,
these
extra
returns
were
generally
not
associated
with
higher
risk.
The
chart
below
shows
that
compared
with
high
ESG
risk
portfolios,
the
standard
deviations
of
the
low
ESG
risk
portfolios
are
either
lower,
for
example
in
Europe,
the
US
and
Canada,
or
comparable,
for
example
in
the
Asia-Pacific
region.

While
the
United
States
and
Canada
had
a
narrower
positive
return
spread
in
the
chart
above,
the
volatility
difference
shown
below
is
more
substantial—highlighting
the
downside
protection
low
ESG
risk
portfolios
offer.

Average
Annualized
Standard
Deviation
Across
Regions

Not
Every
Sector
Rewards
Low
ESG
Risk

The
results
indicate
that
investing
in
lower
ESG
risk
portfolios
is
particularly
rewarding
in
the
healthcare,
consumer
cyclicals,
utilities,
and
basic
materials
sectors,
with
a
positive
return
difference
between
low
and
high
ESG
risk
portfolios
in
all
regions.
Lower
ESG
risk
in
industrials
works
well
in
Europe
but
seems
to
have
a
neutral
outcome
in
the
US
and
Canada
and
in
Asia-Pacific.

In
the
technology
sector,
low
ESG
risk
generates
strong
returns
in
Europe
(up
25.9%
per
year)
and
is
slightly
effective
in
Asia-Pacific
(up
2.1%)
but
then
underperforms
in
the
United
States
and
Canada
(down
6.9%).

Cumulative
Return
Difference
by
Sector
Between
Low
and
High
ESG
Risk
Portfolios

This
could
be
because
large
US
tech
companies,
by
far
the
best-performing
in
recent
years,
actually
score
poorly
on
ESG
metrics:
The
ESG
Risk
Ratings
for
big
names
such
as
Amazon.com [AMZN],
Meta [META],
or
Alphabet [GOOG] are
classified
as
High.
In
most
cases,
this
is
attributable
to
the
companies’
involvement
in
controversies.

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