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Can ESG investing protect investors in a downturn?

As the coronavirus spread continues to push markets on a downward spiral, investment commentators have agreed ESG investing could offer an element of downside protection as a result of the additional scrutiny placed on company business models, governance and work practises

Since the movement of covid-19 outside of China towards the end of February, global equity markets have been in freefall as investors forecast the damaging economic and financial impact on individuals and businesses.

From 19 February to 11 March, the FTSE 100 and All-Share are down over 20%, the S&P 500 has fallen 18.6% and also had to suspend trading, and the MSCI ACWI is down 17.8% in sterling terms, according to FE.

This is despite emergency interest rates cuts from the Bank of England and Federal Reserve, action from the European Central Bank and a budget in the UK focused on measures limiting economic impact.

Investment commentators interviewed by our sister publication ESG Clarity said the sell-off had been indiscriminate; but looking at investments through an ESG lens may have helped investors avoid the less resilient business models.

“We believe that an investment-led and materiality-focused ESG integration program can help minimise downside risk otherwise not captured by traditional financial analysis,” said Guillaume Mascotto, head of ESG and investment stewardship at American Century Investments.

“Investments with systematic ESG integration (not an ESG product per se) could offer exposure to higher-quality issuers with strong ESG risk management practices, and ultimately help investors during a period of uncertainty,” he added.

Ben Palmer, investment director and head of responsible investment at Brooks Macdonald, noted that over longer time frames “companies that exhibit strong ESG credentials have the ability to outperform the peer group and wider market”.

“Reducing business risks around a company’s ESG footprint can help reduce the likelihood of reputational damage or regulatory cost, which can in turn negatively impact share prices,” he explained.

Andrew Parry, head of sustainable investment at Newton, also commented that investing in ESG doesn’t mean investors are going to avoid a big drop, but there may be other factors that will serve ESG companies well in tough times.

“Having a robust balance sheet, good market share and good corporate governance will get them through the bad times,” he added.

While it was highlighted that sustainable companies may not have fared well in previous downturns, with Ryan Hughes, head of active portfolios at AJ Bell, pointing out ethical funds were among the worst performers in the tech bubble due to their high exposure to growth companies, this time may be different.

Charlie Thomas, manager of the Jupiter Green Investment Trust, said in the lead up to the global financial crisis, sustainable solutions companies were the “market darlings”, mirroring somewhat how they have been perceived in recent months.

“However, whereas the policy response back then did little to protect the sustainable solution sectors, in fact undermining the investment case across investment themes such as alternative energy, circular economy and sustainable mobility, our sense is that key initiatives like the European Green Deal now provide a framework with which to flex both monetary and fiscal policy muscle if it is needed.”

Kames Capital’s investment manager of global equities Craig Bonthron added an ESG focus skews investors in favour of quality companies and away from those that have been hit hardest recently.

“ESG is a good proxy for quality in our view. Equity markets are trying to price in demand shock of covid-19, by targeting the sectors most affected by the virus, which are predominantly capital intensive and cyclical sectors of the market, particularly those with globally integrated supply chains or which are exposed to discretionary travel and consumer activity.

“Whilst a traditional investment manager with an ESG tilt may have chosen to have exposure to these areas of the market, an ESG-focused approach will typically lead to higher quality companies, with stronger balance sheets.”

Interestingly, when comparing the falls of the wider indices with more sustainable focused indices, there is a slight positive difference. MSCI’s Global Sustainable Water, Global Green Building, Global Pollution Prevention and Global Environment saw falls of 15-17%, compared with the global equity market drops of nearer 20% or more.

Deeper scrutiny

M&G’s head of sustainable and impact investing, Ben Constable-Maxwell, said investing with an ESG lens was essentially a risk management mechanism as managers take a more holistic approach in their company analysis.

“We tend to scrutinise companies in a deeper way. This should help make better informed decisions on the durability and sustainably of companies.”

While he was quick to point out this does not mean ESG investing is less risky, greater understanding of the risks should lead to better informed decisions.

“These companies have better governance, pollute less and treat people better. These tend to be successes over the long term and that is a positive for investors.

“Also, the companies that manage their people well, have flexible working practises built in, have diverse supply chains. They will have a greater strategic resilience because of good management, governance and good ESG standards.

“ESG on its own is not a safe haven but good risk management aligned with companies that are more sustainably oriented – that is a powerful combination,” he explained.

Derek Brander, head of UK distribution at Candriam, even went as far as saying ESG investing could be likened to a safe haven: “Global economic downturns, recessions or ‘black swan’ events – like we are potentially experiencing right now due to covid-19 and the oil price – can put severe downward pressure on all investments, regardless of how promising it might be in terms of ESG.

“However, robust and consistent ESG performance helps investors to commit through a cycle and over the long term. They don’t tend to dump these assets so easily, and therefore it gives that investment a better chance of recovery and growth. In that sense, high quality ESG can have some downside protection and even safe haven-like features.”

Oil vs renewables

One obvious factor is that ESG investors are less likely to be exposed to oil and gas stocks, which have been “getting smashed” in the recent volatility, said Hawksmoor Investment Management senior fund analyst James Clark.

“If you have a sustainable investment approach you are more likely to avoid high carbon, dirty polluting companies,” said M&G’s Constable-Maxwell.

On the flipside, he added that companies that are skewed towards wind and solar have held up “remarkably well” while Annabel Brodie-Smith, communications director of the Association of Investment Companies (AIC), said  Renewable Energy Infrastructure has been the best-performing investment company sector during the recent period of market volatility.

“The sector has been in strong demand for its high yields and the assets these investment companies invest in such as anaerobic digestion plants, wind farms and solar parks have a lower correlation to the wider stock market,” she said.

“Investment companies in the environmental sector are amongst those that have suffered the least during the recent market sell-off. These companies back businesses which are powering the move to a lower-carbon future in areas such as water treatment, recycling and sustainable food.”

Additionally, Hawksmoor’s Clark said sustainable fixed income products with longer duration held in their portfolios have held up better than non-sustainable peers.

Too early to tell

Nonetheless, investment commentators also urged investors to consider that ESG investing is certainly not immune from downfalls and this period of volatility is the first real test.

Clark commented: “The rise of sustainable investing has come during prosaic market environment when equities have generally been going up. It hasn’t been tested in a downtime, but it looks like we are about to find out.

“In theory, there should be a bit of downside protection but this sell-off has been indiscriminate so in practise, it’s quite different.”

Newton’s Parry also said in times of extreme market movements, there are high levels of correlation and it becomes very hard for investors to hide from this, especially if there are several waves of panic.

“ESG investing won’t protect investors from market paranoia, but it might help them identify the companies that have the resilience in their business model to benefit from over the long term,” he said.

ACI’s Mascotto also cautioned that while ESG assessments can help investors increase exposure to quality, and better understand risk profiles this “may not necessarily translate into material risk/reward variations”.

AJ Bell’s Hughes added: “It is difficult to generalise given the wide range of companies that now appear in ESG focused funds and this is the first real test of the sector since its strong emergence in the last couple of years.”

He said he does not see a compelling argument as to why ESG focused investments should protect investors better in a major market downturn as investor behaviour in these instances tends to be “pretty indiscriminate with most rational and logical thinking going out of the window”.

“With oil falling 30% in a day, we are actually in a strange place where fossil fuels might suddenly look very cheap compared to renewables,” he continued.

“Notwithstanding the environmental pressures, with fuel becoming significantly cheaper, it may actually slow the uptake of renewables in the short term, particularly in those countries that remain heavily reliant on oil.”

The resounding message from the managers interviewed, and is clearly not exclusive to ESG investing, is to do your homework. It has been well-versed that the definitions of ESG can differ by company, region and investor and therefore investors should always be looking under the bonnet rather than simply applying a one-size-fits-all filter.

David Harrison, manager of the Rathbone Global Sustainability Fund, said: “The most important thing is how ESG is linked back to the performance of the company. For example. companies can say they are ESG but then it is not followed through with how the company is run or how the senior management is incentivised. Where there isn’t a link is a big red flag for us.”

He added companies that are truly “ESG-savvy” think about their supply chain as well as their business model which gives them “better protection in terms of reputation and prevention of catastrophe”.

“ESG stocks are not safe havens but ESG considerations can make a franchise more durable and have an economic model that is harder to break down.”

Graham Clapp, manager of the RWC Continental European Equity Fund, added “Investors should be approaching this trend with caution. We are seeing increasing evidence that investors are ignoring fundamentals in the hope of finding the long-term winners which can tackle environmental problems.

“We have seen numerous examples across Europe where markets are being driven by theme investing – buying companies just because they have an ESG angle, regardless of whether or not they’re actually executing very well.”

Comfort blanket

While the interviewees agreed calling ESG investments a safe haven was a step too far, there are elements that should make investors feel better about where they have placed their portfolio.

M&G’s Constable-Maxwell explained: “With impact investing we are trying to support and develop a shift away from focusing just on financial returns. Impact investors can make decent financial returns but also positive social and environmental returns.

“It enables investors to say, ‘I am helping through my investments that are addressing the world’s big social and environmental problems’.”

Next steps

As previously highlighted, this period of volatility will be testing for all stocks regardless of ESG credentials and the message is “do not panic and stay invested”, according to ACI’s Mascotto.

“The second recommendation we’d make is to pivot toward an ESG active barbell approach by increasing exposure to investments in high quality and attractively valued issuers with more exposure to domestic markets (vs dependent on global value chains) and strong margins of safety against rising “covid-related costs” and solid ESG risk management practices,” he said.

With prices falling to such extreme levels investors should be looking at where they can top up.

“Ultimately, assets are a lot cheaper than they were a month ago, use the market weakness as a opportunity to look for bargains,” said Newton’s Parry

For more insight on ESG investing, please click on www.esgclarity.com

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