For the 5 years through the end of 2020, the Morningstar Australia Sustainability Index recorded a 9.5 per cent average annual gain, compared to 8.8 per cent for the index from which it is derived—the Morningstar Australia Large-Mid Cap Index. During rough patches like the fourth quarter of 2018 or the first quarter of 2020, the index declined less than the market.

Australia is no exception. According to a recent study of nearly 70 unique Morningstar indexes focused on markets across the globe, environmental, social, and governance (ESG) criteria added value and dampened volatility.

Sustainability rising

For sustainable investing, 2020 was a landmark year. The coronavirus pandemic and its societal impact, the global movement for racial justice, and the ongoing threat of climate change all reinforced the relationship between investing and environmental, social, and governance-related issues. "Stakeholder capitalism” became an increasingly mainstream concept. And investors sent record capital flows to ESG funds. In Australia, retail assets invested in sustainable funds as identified by Morningstar topped a record $25 billion, according to the Sustainable Investing Landscape for Australian Fund Investors Q4 2020. In the US, assets pushed past US$250 billion ($322 billion) and European assets past 1.1 trillion euros ($1.7 trillion), according to Morningstar data.

What about performance? A persistent perception holds that ESG-based investing requires a performance sacrifice. Another common assumption is that ESG screens have led to good performance recently because they skew toward the technology sector, which has led the market, and away from energy, the biggest laggard.

Morningstar Indexes' examination of its various ESG-screened benchmarks found:  

  • 52 of Morningstar's 69 ESG-screened indexes (75 per cent) outperformed their broad market equivalents in 2020
  • 57 of 65 ESG indexes (88 per cent) outperformed for the five years through the end of 2020
  • 59 of 65 ESG indexes (91 per cent) lost less than their broad market equivalents during down markets over the past five years, including the bear market in the first quarter of 2020.
  • ESG outperformance is not just about sector bias.
  • ESG screens have contributed more to performance outside the US than within the US market.

The Morningstar Australia Sustainability Index owes its record partly to below-market weight to the banks. But it was also boosted by above-market weight in stocks like Wesfarmers, Fortescue Metals, and Growthpoint Properties. The index methodology is aligned with the Morningstar Sustainability Rating for funds and emphasizes companies with low ESG Risk as assessed by Sustainalytics, Morningstar’s ESG research arm.

Other index families studied include Sustainability Leaders, Low Carbon Risk (methodologically aligned with the Morningstar Low Carbon Risk designation), Renewable Energy, and indexes screened on diversity and inclusion criteria. The study includes some back-tested performance, which relies on historical ESG assessments.

ESG around the world

In recent years, ESG screens have been more successful outside the US. In Europe, stocks like Allianz, Novo Nordisk, and ASML have boosted Morningstar’s ESG indexes. So has avoidance of HSBC and British American Tobacco. In Asia, Taiwan Semiconductor, Keyence, and Alibaba have contributed. Meanwhile, the Morningstar US Sustainability Index lagged the market in both 2020 and for the five-year period despite above-market exposure to technology and little in energy. Some of the US market’s top recent performers, such as Tesla, Amazon.com, Facebook, and Alphabet, are not included in the Morningstar US Sustainability Index because of their ESG Risk levels as assessed by Sustainalytics.

While relative returns shift depending on market conditions, the ESG indexes’ ability to protect on the downside is likely more enduring. Morningstar has observed a relationship between ESG Risk and economic moat, or sustainable competitive advantage, which contributes to resilience. Companies with economic moats tend to carry less ESG Risk and lower volatility. Morningstar’s ESG indexes’ lower downside capture ratios owe to their better than market returns during times like the first quarter of 2020 or the fourth quarter of 2018.

Overall, Morningstar’s ESG indexes’ risk/return profile should encourage investors concerned about a return sacrifice associated with sustainability screens. Results also support the notion that ESG issues represent material financial risks.