ESG funds don't underperform - but nor do they outperform

-- | 15/10/2021

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Emma Rapaport: Hello, and welcome to Morningstar. I'm Emma Rapaport. Sustainable investing is one of the fastest growing trends in the asset management industry. Here with us to talk about whether or not ESG funds are delivering for investors is Tim Murphy. He is a Director in our Manager Research team and the chief architect of Morningstar's model ETF portfolios.

Tim, thanks very much for joining us today.

Tim Murphy: Good morning, Emma.

Rapaport: Tim, I think it's fair to say that ESG funds have, in general, outperformed particularly during the pandemic. Could you discuss why these funds have outperformed and whether or not that you've continued to see outperformance in the last six months or so?

Murphy: Yeah. So, there have been a range of outcomes from ESG-tilted funds. And so, we certainly sought to write a paper and explore what is the empirical evidence around some of these hypotheses and views that are out there. Certainly, there were definitely through the course of 2020 themes like technology and healthcare did very well, which have tended to have higher exposure from ESG-tilted funds. But equally, this year or probably since late 2020 we've seen a rebound in commodity prices, fossil fuels in particular, coal prices hitting all-time highs more recently. So, of course, the opposite of that has been true in 2021.

But when we're thinking about performance in assessing funds, we're always thinking about things over the long term. And so, we recently wrote a paper looking to explore the empirical evidence over longer three and five-year periods for ESG funds, because a lot of these shorter-term things tend to wash out over longer term. And so, what we did was look at the performance of global equity funds available for Australian equity investors, how have they done both on a return and a risk spectrum relative to broad market indices and peer groups. And what we found was certainly over five years no discernible difference on average to the broader market. Some funds are higher return and higher risk, some funds were lower return and lower risk. Over a short a three-year time period, where we've got a more meaningful sample size given there has been a lot of growth in products in recent years, the performance is slightly better on average. So, the encouraging thing that we took out of that is that you're not necessarily giving up anything by having a tilted ESG portfolio. Certainly, there's been one viewpoint among investors out there is if you're restricting part of my investable universe, then that should limit my opportunities, and by inference limit my returns. But what we've seen to-date doesn't support material outperformance but doesn't support materially different underperformance either.

Rapaport: So, you'd say it's better said that narrative of having to accept underperformance to invest in line with your values is dead?

Murphy: Certainly, the evidence doesn't support that today. I think, like anything, there's a range of different ways of approaching ESG investing. And so, that's certainly we're having detailed data and tools to analyze the different approaches is really, really important because we are seeing a range of different funds come to market that all have ESG or sustainable in the name, but actually have very, very different ways of doing that under the hood. And so, that's certainly what a lot of our research aims to identify and seek out. But certainly, when looking at across a broad sample set, on average, we're able to conclude that investors that want to or increasingly want to align their investment portfolios with their own values, pressing that through ESG funds, they haven't had to necessarily give up any performance or take a higher risk to do that.

Rapaport: So, Tim, for the funds that have the – the ESG funds that have outperformed on a three to five-year basis, your suggestion is that their outperformance isn't anything to do with unnecessarily preferencing ESG-friendly or ESG-risk-less stocks. It's more to do with their general investing acumen or the other things that you would rate and review a fund on?

Murphy: Yeah, for sure. I think it's difficult to conclude that ESG in isolation would be the reason why any fund has outperformed over a given period in most circumstances, and certainly over the periods that we've looked at most recently. What we do as part of our day-to-day work, and certainly what it brought to life in this research paper we've written is look at some of the underlying sector and factor exposures that are typical of ESG funds. And certainly, looking at it on a lot of different factor basis, they're looking at the exposure of these funds to factors like yield, like momentum, like value, like quality, a lot of these sort of traditional metrics that people would analyze and make investment decisions based on. But most of those factors on average – some are higher, some are lower. There isn't a discernible difference. But there was one exception to that which was quality factor. So, the vast majority of ESG funds tend to be overweight the quality factor. So, what does that mean? It means tend to favor funds that rank well on metrics like return on equity. So, they have higher than average return on equity. They'll have lower than average debt. And if you think about that, that is quite intuitive when you think about the characteristics of an ESG-aligned fund, the fact that it would have those characteristics makes intuitive sense, right? So, quality stocks as a factor certainly have outperformed the broader global equity market over the last five years. And so, certainly, we think that that's playing a role in helping some of the funds here that have outperformed within this sample set over the time period.

Rapaport: Tim, you've just done this big review of funds and the way that they manage ESG risk. Is there anything that you would like to see in this industry that's still young and is still growing that you would like to see change?

Murphy: I think we need to see better articulation of the ESG characteristics from different fund managers. So, as I mentioned earlier, there's lots and lots of funds coming to market that have ESG or sustainable in their name, but actually sort of articulating that under the hood with objective data to verify that, that's certainly of increasing importance, a scenario, we spend a lot of time doing to help differentiate as part of our analysis. I'd say there's a couple of fund managers that are good at that, but on average I think that's an area where a lot of funds and ETF providers offering products in this space could definitely improve to help investors understand in more detail which particular ESG characteristic their investment offering really tilts toward or provides you greater exposure to and could therefore help you make that decision if you're trying to align your portfolio to a particular value. Because I guess that's the other thing with ESG investing is that different issues are more or less important to different individuals. It's very individualized topic. So, things like tobacco manufacturing, lots of people in Australia care about that. You go to Europe, for instance, less so. Things like fossil fuel production – again, you get differing attitudes from different investors on that, obviously topical one at the moment given how high the coal prices have jumped most recently. So, being able to individualize portfolios or make individual decisions based on those particular values we think is increasingly important.

Rapaport: Yeah. So, if you had to describe the range of what people or what managers are making transparent is that everything from just saying, you know, we consider ESG risk to putting on their website exactly where within their portfolio they think that they're reducing their carbon risk, or they're reducing their risk of social issues. What's the range of sort of transparency you're looking at?

Murphy: Yeah. So, I mean, basic things from what sectors do we exclude? I mean, that's the very most basic thing we've seen in ESG investing. So, being easy to identify this fund excludes tobacco, controversial weapons, fossil fuel production or whatever other particular exclusions it may have in place so that investors can easily identify that. As I said, some are good at doing that, some less so. And certainly, at Morningstar, we sort of capture that data to help investors be able to filter on those sorts of issues. But then, from an impact of positive perspective, really looking to identify not only how does the process look for stocks exposed to a particular theme, but then how does their portfolio measure, how do you quantify that versus a broad index fund for instance so that it's very clear and easy for investors to understand if you buy our fund instead of broad index funds, you get that lower carbon exposure depending on your metric, lower exposures to fossil fuels, lower exposures to weapons or bad labor practices.

Rapaport: So, if an investor is considering integrating ESG into their portfolio, they're considering some ESG funds, what are some of the things that they should look for in a top-performing fund?

Murphy: Yeah. So, there are things to consider. First of all, I mean, even ignoring performance, you want to think about what are your values that you're wanting to align to, and make sure that you're narrowing your focus to funds or ETFs that have similar values to that, first and foremost, if that's what's driving your decision. Once you've got a list of funds that meets those criteria, then obviously you want to look for funds that have a longer-term focus, that have detailed – in an active fund, a detailed thought-out process and a skilled team behind what they do. If it is a more sort of rules-based or passive offering, then do the rules of that makes sense, have they stood the test of time, has that index been around for a while or was that index created last week because someone thought they could build an idea that an ETF provider would make (indiscernible). So, I think there's lots of long-term versus short-term decisions to think about when selecting investments and really trying to look past a lot of that short-term noise.

Rapaport: Great. Thank you very much for joining us today.

Murphy: Thanks Emma.

This report appeared on www.morningstar.com.au 2022 Morningstar Australasia Pty Limited

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