Mutual funds and ETFs investing according to environmental, social, and governance (ESG) standards built a powerful record over the past decade, delivering higher average annual returns than non-ESG peers, with lower volatility. But lately, ESG investments haven’t been living up to their reputation. On average, ESG funds and ETFs have suffered deeper losses with more bruising along the way than those without values-based mandates.
Over the six-month period between December and May, the broad universe of large blend U.S. funds and ETFs was down 8.16% and had a standard deviation of 4.95, according to Morningstar Direct, the Chicago-based fund and ETF tracker. Standard deviation is a volatility measure; the higher it is, the more the variance in price.
Large-capitalization mutual funds and ETFs with the lowest ESG scores—meaning they invest in companies with products or policies that pose a high risk based on ESG measures—held up better than the average fund in their category. They were down 7.08% over the same period and their standard deviation was 4.88. These funds also beat the S&P 500, which was down almost 8.5% for that period.
But the high-scoring ESG funds and ETFs in the large-cap category fared the worst: down 8.58%, with a standard deviation of 5.04, according to Morningstar Direct. These are investments whose portfolios have the distinction of at least four globes in Morningstar’s ESG risk rating system. The maximum number of globes is five, indicating the lowest ESG risk.
The idea behind the risk rankings is that all companies pose some ESG risk, whether it is a manufacturing company challenged to minimize environmental risks of its wastewater or a tech company with a responsibility to secure data to minimize social risks. Morningstar aims to identify high- and low-risk companies, factoring in how well they are managing their ESG challenges.
Sectors tend to have their own ESG risk characteristics. While the highest-risk companies are typically in the industrial, real estate, and commodity-based companies, such as in energy, utility or mining companies, technology and communications sectors generally have low ESG risk.
Many ESG funds have a natural tilt toward growth—some 95% of all ESG stock mutual funds and 90% of ETFs are categorized as either blend or growth portfolios—and have benefited as growth stocks fueled the longest bull market in history between 2009 and the recent market rout.
“The higher volatility of funds with four or five globes over the past year can be partly attributed to differences in sector allocation. These funds tend to overweight technology and communications stocks, which have taken a beating in recent months. They fell from record highs,” says Hortense Bioy, global director of sustainability research at Morningstar. “Conversely, funds with four or five globes tend to underweight sectors with higher ESG risks such as oil and gas, which have been consistently trending upwards.”
The S&P 500’s information and technology sector sold off 28% this year through mid-June, and the communications services sector was down 31.5%. Meanwhile, portfolios light on the oil and gas sector missed out: These stocks were up more than 55% by midyear.
Peter Krull, CEO of Earth Equity Advisors in Asheville, N.C., points to a preponderance of evidence that indicates values-based investors should size up volatility and returns over the longer term—and if they hang in there are likely to be rewarded.
“Using ESG metrics can lead to a better long-term investment because you’re not only looking at more risk factors—climate risk, social risk—but at factors that create opportunities, like how many women are on the board or in the C-suite,” Krull says. “In times like now, when markets are down and growth is down, is when to accumulate shares, because the tech and innovation will lead us into a new economy.”
This article appears in the September 2022 issue of Penta magazine.