By Justin Choung
While the worst of the coronavirus pandemic left the world’s financial markets tumbling with record outflows from investors, ESG funds saw record highs in demand and have generally outperformed the market. ESG funds received net flows of $20.9 billion during Q1 and Q2 of 2020, a figure that nearly matches previous record net flows of $21.4 billion for the entire year of 2019. In addition to record-setting demand, ESG funds have largely outperformed their traditional counterparts, especially during the worst months of the pandemic. A Morningstar report tracked 26 ESG funds during Q1 and found that 24 of them outperformed similar, conventional funds that covered the same sectors; a Morgan Stanley report also found that sustainable equity funds outperformed traditional equity funds by 3.9% during the pandemic. The impressive recent performance of ESG funds has reinforced supporters of a recent shift in investor thinking towards stakeholder capitalism and sustainability, although critics remain unconvinced, with particular skepticism towards the fundamental approach of ESG investing.
A Shift in Investor Thinking
The rise in demand for ESG funds reflects a fundamental shift in how investors consider ESG criteria, which are standards that measure a company’s sustainability based on its environmental, social, and corporate governance. Even before coronavirus emerged, the theory of stakeholder capitalism – that companies should expand their singular focus on shareholder returns to encompass all stakeholders – was becoming increasingly popular. The pandemic has accelerated this trend, revealing the extent of potential consequences faced by companies that focus exclusively on shareholder returns.
Jon Hale, the director of Sustainability Research at Morningstar, emphasizes the controversy surrounding how companies have treated their employees and customers during the pandemic, saying that “so much of even corporate value these days is based on intangible assets like your reputation, and I think stakeholders will remember how companies either rose to the occasion or failed.” Hale’s prediction projects potential consequences for companies that fail to protect their employees and customers either physically or financially, the effects of which could have lasting impacts in the future.
Support for sustainable investing has been bolstered in recent months by the considerable success of ESG funds during the pandemic, which is considered the first significant test for what critics have deemed a bull market phenomenon. The pandemic has demonstrated to investors the capacity of ESG funds to withstand market downturns, which should increase confidence in this style of investing.
Criticisms and Flaws in ESG Investing
In spite of the strong performance exhibited by ESG funds over the course of the coronavirus pandemic, criticisms remain with respect to the fundamental approach of ESG investing and the credit ESG funds deserve for their performance. A prominent criticism of ESG investing is that ESG ratings are subjective and inconsistent; there is no objective standard for how to measure ESG factors, and investors often face difficulties in trying to find ESG data on companies. As a result, companies with questionable ethics and environmental, social, or governance impacts might still rate highly based on a fund’s ESG metrics.
Critics have also argued that ESG factors are not actually responsible for the performance of ESG funds during the pandemic. A study published by NYU Stern’s School of Business claimed that ESG metrics “offer no such positive explanatory power for returns during Covid-19.” The study argues that instead of ESG factors, positive stock performance during Q1 was driven by firm liquidity, leverage and cash positions, and intangible assets. While the study acknowledges the long term importance of corporate responsibility, it also offers a significant challenge to the supposed success of ESG investing.
Given the considerable criticism surrounding ESG investing, the debate over ESG funds is far from over. This form of investing is still a fairly new phenomenon, and further historical evidence of its performance is necessary to evaluate its effectiveness. There is also a need of significant standardization in its fundamental approach and use of data to appease critics. While ESG funds have passed their first significant test against the coronavirus, their validity still remains unproven.