Morningstar’s latest analysis of ESG investment product performance shows that there is no performance trade-off over the medium- to long-term.
- The battle over ESG in the US seems to be driven by Republican beliefs that ESG is a ‘woke’ agenda that will lose its citizens money.
- Yet, while ESG funds may lag behind traditional funds in the short-term, they show increased resilience and improved performance over longer periods of time.
- Poor performance in 2022 could be due to sectoral bias, as ESG funds tend to be underweight in energy stocks, which were buoyed by inflation and the energy crisis.
Despite the increased popularity of ESG investment offerings, concerns remain about a potential performance trade-off. Morningstar’s latest report How Do ESG Funds Perform? examined the performance of ESG funds versus traditional peers in 17 European Morningstar Categories, over the past one, three, five, and 10 years. The report covers almost 8,000 funds domiciled in Europe, including over 2,000 ESG open-end and exchange-traded funds.
“Trade-offs and performance of ESG investments will continue be debated and researched. But what we found again by analysing ESG funds in the most popular asset classes is that there is no performance trade-off over the medium and long term. That’s important for sustainability-oriented investors because of the persistent perception that ESG-based investing requires a performance sacrifice.” – Hortense Bioy, Global Director of Sustainability Research, Morningstar.
A growing body of research shows that the consideration of material ESG factors has a positive effect on investment performance, but there have also been indications that there isn’t a clear link between firms’ ESG attributes and their overall performance. This has led to speculation that apparent correlations should not be perceived as causation. The latest study from Morningstar builds on this work, providing an update on the analysis of European ESG funds done in 2020.
As the report says: “The year 2022 was tough for investors, with inflationary pressures, rising interest rates, recession fears, and the energy crisis affecting almost all asset classes and ESG funds were not immune.”
This analysis compared the average returns of both ESG and traditional fund cohorts in 2022 and over the past three, five, and 10 years. Morningstar then evaluated ESG funds against a composite of traditional funds in each category, measuring the odds of picking a winner. It went on to examine the performance of ESG funds using other tools, including the Morningstar star rating and Morningstar Medalist rating.
Throughout the study, ESG funds were defined as those that claim to focus on sustainability; impact; or environmental, social, and governance factors. The category does not contain funds that employ only limited exclusionary screens without a broader emphasis on ESG, nor does it include the growing number of funds that now formally integrate ESG factors in a nondeterminative way during their security selection.
Key findings in terms of ESG product performance
The average returns and success rates identified across the report’s sample suggest that there is no performance trade-off associated with ESG funds over the medium- and long-term. In fact, over three, five, and 10 years, the average ESG fund beat its corresponding conventional peer.
Over the short-term, as evidenced in 2022, ESG funds may lag behind traditional funds, mainly because of structural biases. Last year, only four out of 10 ESG funds in the sample outperformed their traditional counterparts, although those in certain equity categories had shown an improved success rate towards the end of the first quarter of 2023.
Greater success appears to come through the extended timeline of ESG investments. According to Bioy, “The odds of picking a winning ESG fund with high excess returns relative to traditional peers increases as the holding period extends.”
Of course, there are some caveats to this optimistic analysis. The report states that while ESG funds exhibit much higher survivorship rates than traditional funds over multiple time horizons, the odds of picking a winning option are likely to drop in the coming years, partly because of the recent proliferation of ESG funds. With that said, lower-cost ESG funds have greater odds of success.
Perhaps most interestingly, a similar proportion of ESG funds (36%) and traditional funds (35%) carry 4 or 5 stars, but significantly more ESG funds (38%) than traditional funds (32%) are awarded Gold, Silver, and Bronze ratings. This means that Morningstar analysts have stronger conviction in the ability of ESG funds to outperform.
As the body of evidence continues to build, it is difficult to understand ongoing concerns about the use of a risk-adjusted lens when selecting investments. Political opposition to action on climate change may be understandable, if misguided and driven by short-term focus and interests, but it remains baffling that new approaches to understanding risk are under attack.
The improved performance of some companies addressing ESG issues may simply be due to improved governance. Indeed, Elon Musk has attacked the ESG approach because there are tobacco companies with a higher rating than Tesla. While Tesla may be a driver of interest in electric vehicles, this does not equate to its consideration of the full scope of ESG issues such as governance, social impact, overall climate impact and performance. Understanding climate risk and ESG requires patience and a degree of comfort with uncertainty, which doesn’t appear to be a particular character trait of Musk.