Sustainability advocates find ESG focus is paying dividends

Sustainable practices are holding up well in the global coronavirus pandemic, a bright spot amid the upheaval in communities and markets.

After all, advocates say, good ESG practices are all about risk management. "This has really put the spotlight on how well prepared companies are to manage for a big systemic risk," said Libby Bernick, head of sustainability at Morningstar Inc. in Philadelphia. As companies respond to both the pandemic and the related market sell-off, "investors will be looking at their portfolios and saying, 'What kind of long-term value did they create?'" she said.

Ms. Bernick said that until the pandemic-related market sell-off, there was strong demand for corporate ESG practices across all demographics. And so far, "when we look at the data on performance, we see those companies outperforming."

In 2019, Morningstar data show a nearly fourfold increase over the previous year in flows into U.S. sustainable funds, at $21.4 billion. The first quarter of 2020 also saw record flows into ESG funds and indexes, and by the end of the quarter they outperformed their conventional peers. "This whole data narrative is very strong. We are seeing sustainable funds outperformed others in this downturn," Ms. Bernick said.

Sustainable funds in the U.S. set a record for flows in the first quarter despite the downturn, with 314 open-end and exchange-traded funds marking flows of $10.5 billion. The pandemic's effect is noticeable by month, with January marking a record monthly high of $5.2 billion, but by February falling to $3.7 billion and $1.6 billion by March, according to Morningstar. During the first quarter, returns of sustainable equity funds were clustered in the top halves of their respective categories, and more sustainable funds' returns ranked in their category's top quartile than in any other quartile. The returns of 70% of sustainable equity funds ranked in the top halves of their categories and 44% ranked in their category's top quartile.

An MSCI comparison of four standard MSCI ESG indexes to their parent indexes during the COVID-19 sell-off found that the ESG ones, representing a range of approaches, all outperformed the parent index in the first quarter of 2020.

The SRI index was the strongest performer, with a one-year return of -5.2% as of March 31, compared to -10.7% for MSCI ACWI. Three other MSCI ACWI ESG indexes — Universal, Leaders and Focus — returned -8.4%, -8.5% and -9.2%, respectively. MSCI attributed the outperformance of all four mainly to equity style tilts, with ESG the strongest factor, followed by tilts toward lower beta, lower volatility and better quality.

Doug Morrow, director of portfolio research for Sustainalytics in Toronto, which Morningstar is in the process of acquiring, is not surprised about better performance. "There has been evidence building for a long time that companies that do well on ESG perform well during a crisis," he said.

Sustainalytics is now researching how specific asset classes or ESG topics are performing during the pandemic, but Mr. Morrow cited two factors already expected to help ESG funds. "We know that ESG funds and indices tend to be underweight energy, or ex-energy … which has been hit harder than other sectors, and we've known for a while that ESG tends to be strongly positively correlated with the quality factor. What we've found is that companies with better management quality have healthier balance sheets," Mr. Morrow said.

Analysts at Fitch Ratings Inc. predict that both traditional and alternative investment managers prepared to offer credible ESG-oriented investment options could see a competitive advantage. While fund launches or fundraising plans may be delayed by the pandemic, the longer-term focus on ESG should continue to be supported. "The coronavirus may further fuel ESG distinctions to the extent companies' activities and/or behaviors during and after the pandemic influence social perceptions," Fitch analysts said.

More attention to risk management is a boost for ESG analysis, which "is really coming to the fore right now," said Erika Karp, founder and CEO of Cornerstone Capital Inc., a New York sustainable and impact investing consultant working with corporations, asset owners and financial institutions to promote ESG capital. "It's just a broader, longer term risk-adjusted return analysis that gives you a different perspective around risks and opportunities."

The question of whether companies will advance or retreat on sustainability measures as they navigate the crisis "comes up a lot," said Kellie Huennekens, head of ESG research at Nasdaq Inc. "The short answer is that we are going to see an acceleration of trends that were decades in the making. What the coronavirus has done is make us more aware of the fragile nature of things. There is growing recognition that intangible assets are making up a significant portion of corporate assets," Ms. Huennekens said.

That makes governance "first among equals" when it comes to E, S or G, Ms. Karp said. "If a company is well governed, it is always thinking about environmental and social issues. In this respect, governance is a proxy for quality, innovation and resilience."

One governance issue the COVID-19 crisis has moved to the forefront is human capital management. Companies are being watched to see how they help employees deal with pressing health, safety and paycheck issues. What had been a growing focus on workforce diversity is now shifting to wage inequality between executives and other workers. Companies are also rethinking the workplace altogether, as working from home becomes the new normal, ESG investing experts say.

"I think this going to have a big, big impact on executive compensation structures and on the future of work," said Calvert Research and Management President and CEO John Streur in Washington. "CEOs are going to be called upon to create space for the lower-paid workers."

Calvert Research and Management, with $22 billion in assets under management, is part of Eaton Vance. Calvert's U.S. ESG index fund is outperforming its benchmark by 110 to 120 basis points, driven by limited exposure to fossil fuels and good ESG metrics that helped companies thoughtful about managing social and environmental risks prepare for this latest risk, Mr. Streur said.

The pandemic has also highlighted supply chain weaknesses that companies will have to address. "You are going to see a lot more emphasis on supply chain mapping and understanding where the vulnerabilities are," Sustainalytics' Mr. Morrow said.

"I think this pandemic is going to lead to a rethink of a lot of things, even real estate. There is no doubt this is of enormous interest to investors," he said.

In the current proxy season, companies may be focusing on salient operational issues rather than ESG initiatives, "but we are finding that companies are willing and interested in engaging. For the most part, companies are trying to be very thoughtful about it," said Ray Cameron, head of BlackRock investment stewardship for the Americas, New York. BlackRock Inc. has already engaged with a number of companies, and initial conversations have tended to focus on business continuity. But "a very close second" is how they are dealing with employees, he said.

BlackRock has also focused on overboarding — corporate directors stretched too thin or trying to serve too many companies. "This crisis has really brought it to the forefront. It underscores the importance of board quality," Mr. Cameron said.

Pressure on companies to disclose more about their sustainability plans "may take a bit of a back seat" now that companies are fighting for survival. "But we recognize that it's a very challenging environment and we also recognize that it's a journey," Mr. Cameron said. "There is some early evidence that companies more ESG-focused are starting to recover faster."