Why ESG Is Outperforming The S&P 500

The Coronavirus pandemic is strengthening the hand of ESG investors. Sustainability-themed funds saw record Q1 inflows in the United States, while the rest of the market saw record outflows. Globally, investments in ETFs tracking ESG indices more than doubled, going from $22.1 billion in 2018 to $56.8 billion by the end of 2019, according to S&P Dow Jones estimates.  The pandemic has only reinforced fund managers' belief in ESG, with investors focusing on environmental, social and governance themes.

Rebalancing Act

The S&P 500 ESG Index is designed to be a broad-based benchmark. The screening criteria states that companies are excluded if they have a low ESG score relative to industry peers, are involved in controversial weapons or tobacco, are not closely adhering to the UN Global Compact, or are involved in severe controversies.

Growing regulatory importance makes those firms who are included in the ESG Index perhaps more relevant now than ever before. The need to integrate investors' values in ESG is now also a key consideration for money managers.

ESG Driving Performance

An ESG lens teases out all sorts of risks that are not necessarily apparent in conventional financial analysis. This screening may be the reason that the S&P ESG 500 index has outperformed its parent index in the recent sell-off.

Many observers believe that strong ESG performance indicates better management, and that screening for companies with high ESG scores is simply a way to find good executive teams, which translates into stronger long-term returns. The idea being that management teams that do a good job of minimizing their environmental footprint; promote good employee relations, contingency plan, enforce employee sick leave policies and are prepared for disasters, create resilient governance structures. These types of management teams are more likely to be adept at running all other aspects of a company's business and should be better equipped to ride out a downturn.

ESG analysis regularly focuses on supply-chain transparency. These challenges often occur many steps up a supply chain, and when companies struggle to address them, it's often because they don't know much about where their raw materials are coming from.

For example, as the Coronavirus pandemic started to disrupt supply chains from China and authorities began to shut down economic activity, many companies were caught by surprise when their own products or services were affected leading to stock price shocks.

What Drove the Outperformance?

Of the newly rebalanced ESG index, the index weighting by GICS sector breakdown for the S&P 500 ESG Index as compared to the S&P 500 Index is shown below. Consumer Discretionary, Information Technology, Communication Services and Real Estate all have a higher weighting in the ESG version than the parent index.

The main drivers of the outperformance was a combination of allocation effect (+0.46%) together with selection effect (+2.23%).

In particular, the higher weight allocated to the Technology Sector saw those constituents performing better than those in the parent S&P 500 Index and so contributed to +1.3% outperformance of the S&P 500 ESG than the S&P 500. Outperformance was also driven by better stock selection in the Consumer Discretionary (+0.47%), Consumer Staples (+0.21%), Industrials (+0.35%), and Materials sector (+0.2%).

Better stock selection is the main driver

S&P 500 ESG Index Performance Attribution – Selection Effect

At first glance one may assume that the outperformance is due to the ESG selection criteria making the index under-invested in energy, oil and gas; a naturally more polluting sector.

Oil and gas companies have been among the worst hit in the current downturn for a variety of reasons. The inability of exploration and production companies to curtail production quickly, coupled with lower oil prices, has caused the sector to underperform, comparatively.

However, the market cap weighting to the energy sector is only slightly different between the two indices, hence the allocation is not the driver. The filtering process has seen the ESG index gain performance of +0.07%.

The S&P 500 ESG Index has provided low tracking error relative to the S&P 500, but also performed well due to the way the index methodology sorted the largest companies that drove performance.

Some companies that were significant drivers of the S&P 500's performance in the past 12 months, such as Apple and Microsoft, remained in the S&P 500 ESG Index and were allocated a higher weighting.  Other major companies with less-than-stellar performance, such as Boeing, were excluded.

Another factor affecting a company's ESG score is the strength of its balance sheet. With the exception of Berkshire Hathaway, the same largest ten names by market cap appear in both indices. However given the difference in allocation, the weighting of the top ten constituents is 6.95% greater in the ESG index, and the weight of the largest constituent 1.73% more.

Post COVID-19

The pandemic has only reinforced the focus on ESG and has accelerated its integration into mainstream, core, portfolio selection.

One sign is the continued growth of E-mini S&P 500 ESG Futures, which launched in November 2019. In the six months since launch, the contract has established itself as one of the largest ESG futures globally, trading in excess of $5.6 billion notional with an average daily trading volume of 540 in 2020. Market participants are accessing the ESG futures contract not only to tick the compliance box, but also to enjoy the outperformance.

The underlying index, which has a meaningful filtering methodology and a significant ESG boost, gives investors' comfort that they can integrate ESG into the core of their portfolio whist still achieving a tight tracking error to S&P 500. The 5-year tracking error is 0.83%, allowing clients S&P 500 like performance but in an ESG positive manner.

Further into 2020, as countries emerge out of the Coronavirus crisis, ESG topics may be central to many governments and companies. French and German ministers have called for the EU to expedite their CO2 reduction plans and avoid pro-fossil fuel measures post-lockdown to boost the economy.

In the U.S., companies have pushed for a carbon tax and for green projects to be at the heart of recovery plans. Even within the aviation sector, there is a push towards decarbonization and sustainable aviation fuels. Further, the EU is looking to make emissions cuts a pre-requisite for the bailout of any airline.  If these measures take hold, it appears the trend towards more ESG investing is likely to continue.

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