ESG: weathering the market headwinds

The past two years have been a challenging environment for sustainably focussed strategies. These headwinds were primarily driven by the outperformance of industries which have heightened environmental or social risks. Many of these industries (e.g., coal, tobacco, weapons) are typically excluded from sustainable strategies. Another headwind was the growth bias that sustainable strategies often contain. The strength of energy stocks considering high fossil fuel prices has also been detrimental to sustainable approaches.

This mini-ESG winter has reinforced the need to focus on implementation as well as taking a forward-looking approach. However, it was not impossible for ESG funds to perform well in 2022. Approaches with a value bias and a focus on identifying enablers and innovators as well as best-in-class stocks generally enjoyed better performance. In short, careful implementation of sustainability considerations should not lead to outsized impacts to a portfolio’s fundamental profile or unexpected performance outcomes.

The recent change in market leadership has provided the first real test for sustainable focussed strategies. It has highlighted the benefits of a diversified approach and the importance of allocating to a blend of styles as part of an overall portfolio in a way that also captures sustainability considerations. More generally, we regard the current headwinds as largely transitory and we maintain our conviction that sustainability risks will increasingly be priced over time. The most compelling stocks will have not only the best fundamentals, but also prove to be the most adept at adapting to fast developing sustainability challenges head on.

Recent challenges for ESG-oriented stocks

The standard exclusions based on business involvement have not detracted from performance historically over the longer term, as the below chart illustrates over a range of periods.

However, elevated oil prices as a result of the global economy reopening after the Covid-19 pandemic and supply shortages following Russia’s invasion of Ukraine has meant that any blanket aversion to fossil fuels in a portfolio context has been costly.

Considering volatile and falling markets, defensive industries have also been in favour (e.g., tobacco, alcohol), particularly through 2022, providing additional headwinds to sustainable strategies.

And as geopolitical risks remain high, weapon producers have generated strong profits, boosting stock prices in tandem. These are all areas that are likely to be underrepresented in or excluded from sustainable strategies.

The above chart emphasises that ‘good ESG’ lagged ‘bad ESG’ in 2022 (LHS), apart from governance as well governed companies continued to be rewarded. This is not surprising in an environment where there was also a preference for stability.

The table (RHS) also illustrates the top performing industries in 2022 relative to the MSCI AC World index. The strong performance of tobacco and weaponry stocks, as well as miners, is clear and they were one of the few industries to have posted positive absolute returns outside of energy. In addition, the best performing industries within the energy sector are also the most environmentally impactful - coal and exploration companies. In short, some of the worst areas from an ESG perspective have recently performed best.

It is, therefore, not surprising that naïve approaches to sustainable investing, such as passive sustainability indices, have fallen behind the broader market (chart below), with many of the indices also underperforming in 2021.

Sustainably focused active managers also found this market environment difficult, with the median manager in the below peer group underperforming by 4.0% in 2022 and 1.7% since the end of 2020 (see table below, LHS). In part, this may also reflect the fact that most ESG managers also tend to have a growth bias, which has also been an additional headwind during this period given the sell-off in many of the previously popular big growth stocks (table below, RHS). Looking across a broader universe of more than 600 sustainable funds falling into Morningstar’s Global fund universe, the median passive sustainable ETF has underperformed by 1.8% in 2022 whilst the median sustainable active manager has underperformed by 2.3% in the period.

Value focused sustainable strategies are less common but will have been better placed to capitalise on the rotation of market leadership away from growth. In the Schroders QEP team, our approach to ESG follows an investment philosophy anchored in targeting both valuations and business quality.

The QEP approach to sustainability

In the QEP team we fully integrate sustainability considerations alongside our traditional fundamental measures focused on stock valuations and business quality within our approach to both stock selection and portfolio construction. Importantly, the breadth of opportunities available in global equities allows for the full integration of ESG considerations without having to sacrifice potential returns.

Central to our sustainability assessment is our proprietary QEP ESG Rank, which is utilised as a stock conviction/risk adjustment which impacts stock weightings. Our approach carefully selects the most objective inputs to capture the specific risks that are material to different industries, reflecting both absolute and relative exposure to ESG risks.

While incorporating a view of a company’s current and historical sustainability credentials, we also include forward looking measures and utilise an additional thematic overlay to further prioritise stocks exposed to developing sustainable longer-term themes. This allows us to enhance our focus on both “enablers” and “leaders” from a sustainability viewpoint. Given the way many companies and industries are in transition, highlighting best-in-class companies is particularly important as they will be better placed to manage this evolving landscape.

However, implementation is critical, and the incorporation of sustainability should not compromise an existing investment process. It is particularly important for us to avoid overpaying for stocks regardless of their sustainability credentials. Our disciplined investment process ensures that only stocks which meet our fundamental requirements, alongside attractive sustainability characteristics, are favoured.

With an extensive universe and scalable process there is no need to sacrifice fundamentals for sustainability. The key advantage of a quantitative approach is the ability to exploit a broad opportunity set effectively, allowing the desired fundamental profile of a portfolio without the unwanted sustainability exposures. The chart below illustrates that our investable universe of more than 10,000 global stocks provides more than three times the number of companies rated A or higher when compared to the MSCI AC World index.

Our research also highlights that ESG factors are important drivers across all industries and not just those naturally exposed to heightened sustainability risks, such as high carbon emitters. Our QEP ESG rank has been alpha generative across all market sectors as illustrated below. The results support the view that our interpretation of ESG leaders outperform the laggards over the medium and long term.

The changing face of sustainability

However, sustainability is clearly a rapidly evolving landscape, reflecting both the views of stakeholders and policy makers. The chart below from a recent FTSE Russell asset owner survey shows this, with climate issues falling in importance and social issues now regarded as the most important sustainability concern. This is a clear shift to what has been most in focus in the recent past, although we would stress climate and environmental concerns continue to remain important.

On top of behavioural shifts, data availability and data accuracy is also improving. This allows risks that may have previously been difficult to assess to be more appropriately evaluated. Increasing regulatory burdens and expectations are also encouraging investors to develop their ESG processes in defined ways – the recent introduction of Principle Adverse Indicators (PAIs) in the European landscape is one recent example.

Capturing these developing trends is imperative. Within the QEP team, we have actively been enhancing our social framework in the past 12 months.

An area of focus, in collaboration with the central Schroder’s Sustainable Investment team, has been on human capital management. In this we hope to appropriately capture the impact of corporate culture on potential profitability. We understand that people drive returns, are an appreciating asset and also create economic spill overs.

Looking ahead a key research priority for us this year will be biodiversity, reflecting that environmental impact is far broader than simply focusing on carbon emissions alone.

Bringing it all together

After a bruising year for equities, the additional headwinds against ESG managers has clearly been unhelpful if not understandable given the market backdrop. As with most trends, it is rare that they progress in straight lines and sustainability should not be regarded as an exception to the rule. However, there are ways to mitigate the risks of short term reversions and we would advocate a number of key principles to assist in this journey:

Don’t forget about valuations: incorporating a valuation bias not only provides a more balanced portfolio but also avoids overpaying for high conviction themes that may not necessarily offer the best prospective returns

Maximise the global opportunity set: investing outside of the mainstream indices provides additional flexibility, offering increased options in less analysed areas of the market and further encourages diversification

Be dynamic: Sustainability themes are evolving fast and it is critical to remain ahead of the curve in terms of identifying evolving trends that may play out over several years. Inherently, this requires a forward looking approach that places as much weight on selecting “enablers” and “best in class leaders” today alongside side-stepping the laggards.

Active engagement is key: Through constructive and committed engagement with management teams at the companies and assets we invest in, active ownership is a key element of the value we bring to our clients. Social and environmental forces are reshaping societies, economies, industries and financial markets.

Approached thoughtfully and with focus, encouraging management teams to adapt to those changes, and holding them accountable for doing so, can strengthen the long term competitiveness and value of those assets and can accelerate positive change towards a fairer and more sustainable global economy.