The relative outperformance of ESG funds since the start of the coronavirus sell-off is almost entirely down to low exposure to energy companies.

The past decade has seen the explosion in popularity of ESG (environmental, social and governance) funds. Many arguments have been made as to why investors should consider them, from the moral to the performance based. One persistent argument, however, has been that such funds will hold up better during a market sell-off.

This thesis has been tested somewhat. For example, during the first week of February 2018, most major indices fell by over 10%. Yet during that week, ESG investments appeared to shine, or at least dimmed less than their peers. As Jon Hale, director of sustainable investing research at Morningstar in the US, noted at the time: “Among equity funds, 65% [of ESG funds] outperformed their peers, with more than twice as many finishing in their category’s top quartile than in the bottom quartile.”

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The general reason for this is fairly straightforward: companies that score high on ESG metrics have better governance. Better-governed companies are often those deemed to be higher quality. In times of steep market declines, there is a “flight to quality”.

As Hortense Bioy, Morningstar’s director of passive strategies and sustainability research for Europe, says: “Companies with higher ESG scores tend to be of higher quality, experience lower volatility and be relatively large. This bodes well for the potential of ESG strategies in a downturn.”

Has the same thing happened this time? Looked at in terms of indices, ESG/sustainable assets appear to have held up better. As data provided by Rowan Dartington shows, the MSCI Europe ESG Leaders index (which filters for ESG-friendly companies) has outperformed the broader EU benchmark by 180 basis points since the beginning of the year(to 18 March). Over the same period, MSCI’s Japan and US Leaders indices have outperformed by 50bp.

Comparing funds is slightly harder. It is now common for many funds to claim to have an ESG philosophy built into their stock-picking process. However, as data provided by Willis Owen shows, from the start of the year to 22 March, many funds with an explicit ESG or sustainability focus have been able to produce better results than their sector average and benchmark in both the UK All Companies and Global sector.

UK All Companies

Global

Source: FE Analytics, TR in Pounds Sterling from 1st January 2020 to 22nd March 2020

As readers will see, explicitly ESG or sustainability focused funds have seen outperformance compared to both their sector averages and the sector’s comparable index. But is this because these funds are all invested in higher quality, better-governed companies?

Perhaps. However, the most likely reason for their outperformance appears to be what they are not holding. As Adrian Lowcock, head of personal investing at Willis Owen, notes: “The ESG funds with a strict selection criteria to either actively engage with delivering on ESG or avoid the sin sectors have generally held up better during this crisis. The primary reason for this though is fairly simple – oil.”

He continues: “So any funds which avoid oil, and many ESG funds will be either underweight it or exclude the sector entirely, are likely to have outperformed. Likewise, airlines are another sector to have suffered more than others and again they are not at the front of the queue for ESG funds investing for an environmental or sustainable world.”

The performance of oil companies and airlines is generally cyclical, meaning the fortunes of such sectors rise and fall with the fortunes of the global economy. For instance, in a recession people fly less, and businesses and consumers use less energy. So any downturn is likely to see ESG funds perform at least slightly better.

However, the above mentioned non-ESG sectors have come under particularly unique stress to the coronavirus. Airlines are not just facing a slight scale back in demand: they are facing a long-term global restriction on travel with most flights now grounded. Likewise, an unprecedented state-enforced restriction on economic activity and transport is seeing an expected historic fall in oil demand, way more than the usual recession-induced decline in demand.

Added to that, points out Jason Hollands, managing director of Tilney Bestinvest, is the “bust up between the major oil producers over limiting production, with Saudi Arabia vowing to pump more oil, to grab market share”.

Either way, as Hollands notes: “The relative outperformance of ESG funds is almost entirely down to avoidance – or low exposure – to energy companies, as well as the broader commodities complex.” He continues: “All we can say with confidence is that ESG funds will hold up better during periods of weakness for commodity markets, as we are seeing currently.”