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Ignore ESG funds 'at your peril,' experts say: Sustainable funds outperformed peers in 2020

Last year, ESG funds significantly outperformed their non-ESG counterparts, Morningstar found.

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For years, people feared that investing in line with your values meant sacrificing potential returns. And for years, the naysayers might have been right. After all, the old-school version of socially responsible investing (SRI) focused almost exclusively on steering clear of firms that investors found objectionable, at a time when those businesses — such as energy companies and tobacco firms — were among the most lucrative.

But investors' approach to sustainability has changed, as has the notion that you can't do well financially while also investing toward societal good. So-called ESG funds — mutual funds and ETFs that invest in companies and issuers that rate highly on environmental, social, and government criteria — are among the fastest-growing segments of the market. Investors added more than $51 billion into such funds in 2020 alone.

And investors getting in on the movement have been rewarded. Last year, ESG funds significantly outperformed their non-ESG counterparts, with more than three-fourths of funds besting their peers, according to Morningstar.

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That's not a fluke; it's an early sign that the trends driving ESG-favored companies are here to stay, says Edward Farrington, executive vice president of institutional and retirement at Natixis Investment Managers. "As an investor, these trends are in place, they're multidecade, and you can account for them or not," he says. "But ignore them at your own peril."

Here's why long-term investors should be paying attention to ESG.

ESG strategies seek good businesses capitalizing on long-term trends

While it's impossible to know exactly which businesses will be successful in the coming decades, market-watchers and casual observers alike know that certain trends, such as a transition away from fossil fuel consumption toward clean energy, will affect consumers and corporations alike for decades.

If an ESG fund invests in companies that directly benefit from a transition to clean energy — such as firms that make wind turbines — or in those that have pledged to invest in lowering their carbon footprint, it may well be investing in firms that are well-run and nimble enough to prepare for shifts in the way companies and consumers do business.

Companies that aren't aware of or aren't being realistic about these shifts will be left in the dust, says Andrew Behar, CEO of shareholder advocacy nonprofit As You Sow. "If Exxon believes the demand numbers that they're putting forth, they're not looking at reality," he says. "They say they're moving to plastics, but other firms are cutting plastic and Styrofoam, so what are you looking at? It's an illusion."

As an investor, these trends are in place, they're multidecade, and you can account for them or not.
Edward Farrington
Executive vice president, Natixis Investment Managers

The numbers already bear this out. A recent review of academic ESG studies by NYU Stern Center for Sustainable Business found that companies managing for a lower carbon footprint posted better investing results than competitors, and that corporate sustainability initiatives appear to drive financial performance.

It's not all about saving the planet, either, says Farrington. Good corporate governance plays a huge role in ESG selection. "You have to understand how companies attract and retain employees," he says. "Is there fair pay and paid parental leave? Will people stay at the company for a long time? That's what drives productivity and innovation."

ESG investing can help mitigate risk

Even if you don't buy into the future trends that high-rated ESG companies are investing in, it's smart to consider ESG investing for another reason: to avoid potential pitfalls.

"Risks associated with ESG used to be called 'extra-financial,'" meaning that they weren't thought to directly affect the bottom line, says Nathalie Wallace, head of ESG strategy and development at investing firm Mirova. "We now believe that these are risks that companies should take into consideration and that investors should assess."

Companies that don't take ESG considerations into account may be susceptible to government regulations, reputation-hurting public scandals, and even lawsuits — all of which can ding short-term returns and degrade a company's long-term value, Alex Bryan, director of North American passive strategies at Morningstar, wrote in a recent note.

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Evidence suggests that aversion to companies with large ESG-related risks has boosted sustainable fund performance over time by limiting those funds' losses when markets go down, according to the NYU study. According to researchers, ESG indexes delivered better performance than their conventional counterparts during the 2008 stock market crash, and 24 of 26 ESG index funds outperformed their non-ESG versions during the Covid-related crash in early 2020.

Over time, losing less than peers during market slides makes a big difference. Remember: A 50% loss in an investment means the investment then needs a 100% gain just to break even.

To see how a fund you own, or one that you're considering adding, stacks up in terms of ESG risk, enter its ticker symbol into Morningstar's ESG screener. The tool assigns each fund a sustainability rating: One globe is bad, five globes is best. The tool also shows how each fund compares to its peers on environmental, social, and governance risk criteria.

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