Investing in environmental, social and governance (ESG) areas. has become increasingly popular in recent years as more companies adopt ESG standards. This new asset class comes with the issue of performance.
There is a lot of debate about whether ESG stocks are outperforming the market as a whole. Here’s what investors need to understand about measuring the performance of these investments and the difficulty of determining whether they are outperforming or underperforming the market.
Key learning points
- Companies are moving to an ESG model as a long-term way to improve returns for investors.
- Some companies use the ESG label even though they do not follow principles that ordinary people would call environmentally or socially responsible.
- The results for ESG equities have been mixed, as have the results for mutual funds and exchange-traded funds.
Theory of ESG stocks outperforming the market
ESG stocks, also known as green stocks, are offered by new and established companies committed to creating a better planet and future for humanity. These companies engage in renewable and sustainable practices or seek to promote social responsibility.
Prioritizing these issues results in a company paying more attention to its operations at all levels and being guided by more sustainable principles. In theory, this careful governance leads to better returns and higher profitability, leading some investors and experts to conclude that ESG stocks should naturally outperform the stock market.
This theory has not been proven because investors pay a “Greenium” because of the perceived value of ESG stocks. A 2019 study by University of Chicago researchers published in the Journal of Finance found that none of the ESG stocks outperformed the lowest-rated funds.
One of the difficulties in actually defending or refuting this theory is that ESG stocks have outperformed in some countries than others.
Research has shown that some companies that are supposed to engage in ESG practices ignore these principles when it threatens to hurt their bottom line. This has led to widespread skepticism that underperforming companies will talk about ESG for good publicity, but put these principles and practices aside to ensure their own survival.
It is also theorized that an underperforming company will claim to apply ESG principles to attract attention and money from investors.
But not all companies adopting the ESG label are underperforming and looking for a boost. The companies behind some of the best-performing ESG stocks are large companies that have nothing to lose by moving to the ESG model.
Brief history of ESG investing and controversy
Some experts trace the roots of ESG investing to the 1960s, when concerns about social and environmental issues such as civil rights, gender equality and environmental pollution began to gain ground. However, it wasn’t until the 2000s that ESG investing really became part of the public discussions about institutional and individual investing.
ESG issues were first officially mentioned in the United Nations Principles for Responsible Investment (PRI) report in 2006. This led portfolios to include ESG criteria in their evaluations of companies for the first time.
Over time, increasing investor demand for ESG-related corporate stocks has led to unique indices such as the MSCI ESG Leaders Index and the S&P 500 ESG Index. These indices are designed to measure whether or not companies in different industries meet ESG criteria.
Despite the growing popularity of ESG investing, it has also met with much opposition and skepticism. Some critics have argued that the focus on ESG factors could lead to asset misallocation as money is diverted from companies with solid fundamentals to those that meet ESG criteria.
Other detractors have argued that ESG investing can lead to reduced diversification and potentially lower returns as investors exclude entire industries or sectors from their portfolios based on ESG considerations.
In addition, there is an ongoing debate about the reliability and consistency of ESG data, as different ESG rating agencies use different methodologies. This can lead to different rating agencies assigning different ESG scores to the same companies. The lack of standardization has made it challenging for investors to accurately assess and compare ESG performance.
Why Investors Care About ESG Stocks
ESG stocks are generally low risk. The companies behind them adhere to government regulations that affect their operations and are less likely to become involved in lawsuits.
This kind of conscientious governance also attracts talent who want to use their skills to make the planet a better place to live.
Investors believe that ESG values provide a company with a solid operating foundation and are focused on delivering stable returns. These stocks are excellent for long-term holding strategies as they will outperform over a longer period of time.
Understanding the Greenium
Semi-rational preferences and emotions often play a role in an investor’s decision to buy stocks. An investor may decide to put his money in ESG stocks only because he believes alternative energy and social awareness will help companies survive a paradigm shift.
Meanwhile, another investor might think that brown energy, such as coal, oil or natural gas, is stable and reliable in terms of return on investment and longevity, even though its use is still in the early stages of phase-out.
As investors begin to consider and buy green energy stocks instead of brown for investment, they are willing to pay more for the stock, even though the value may be deceptive. Hence the Greenium.
Greenium plays a role in the value of an ESG stock because of the perception that the company has better governance and is future-proofing itself. While this may very well be the truth, it takes time for these concepts and theories to prove themselves.
It is therefore possible that buying an ESG stock today may not yield value tomorrow if a company does not have its fundamentals in order. This puts investors at risk of losing money on their investments. Investing always involves risks, but ESG stocks may or may not increase those risks because of the Greenium.
Are ESG stocks outperforming or underperforming the market?
MSCI, the current standard for rating ESG stocks, rates companies from CCC to AAA. A company with a CCC or B rating is considered a laggard, BB, BBB or A is average and AA or AAA are leading in terms of ESG standards.
According to MSCI ESG ratings, some stocks are performed better in recent months include Best Buy, Microsoft, Adobe, Intuit, and Nvidia.
There are mixed results when companies challenge ESG theory, and recent stock market losses are distorting how well ESG stocks actually perform.
Investors should remember that we are still in a period of high inflation, even as inflation cools. When you factor in higher interest rates, technology stocks tend to underperform.
The MSCI USA Extended ESG Select Index has outperformed the MSCI USA Index four times over the past seven years, including one year with the same return.
Comparing the MSCI USA Extended ESG Select Index to the S&P 500 Index, the MSCI USA Extended ESG Select Index has outperformed the S&P 500 Index in all but one of seven years. In 2022, the S&P 500 was down 19.44%, while the MSCI USA Extended ESG Select Index was down 21.12%.
This does not mean that all ESG investments outperform the stock market. There are mixed results when looking at some mutual and exchange traded funds. For example, iShares MSCI USA ESG Select ETF (SUSA) underperformed the S&P 500 index last year.
Overall, the data is so mixed that it’s unclear whether ESG is outperforming the overall stock market. As a result, investors must do their due diligence when determining the best ESG investments for their portfolios.
Frequently Asked Questions
Q: What are ESG stocks?
A: ESG stocks are stocks in companies that demonstrate strong environmental, social and governance (ESG) performance. These companies tend to be more environmentally friendly, exhibit good labor and human rights practices, and maintain robust corporate governance structures.
Q: Are ESG stocks outperforming the stock market?
A: ESG stocks have shown mixed performance compared to the broader market. Some studies suggest that companies with high ESG scores tend to outperform the market, while others indicate no significant difference. The relationship between ESG factors and stock performance can vary based on time horizon, industry and region.
Q: How can I identify ESG stocks?
A: ESG stocks can be identified by looking at ESG ratings from agencies such as MSCI. Ratings rate companies based on their ESG performance. You can also check ESG-focused indices, such as the MSCI ESG Leaders Index or the S&P 500 ESG Index, which track companies with high ESG ratings.
Q: Is there a risk in investing in ESG stocks?
A: As with any investment, ESG stocks have inherent risks. However, ESG equities can mitigate specific risks related to environmental, social and governance issues that could negatively impact business performance. It is critical to maintain a diversified portfolio and consider various factors, including ESG-related policies, when making investment decisions.
It comes down to
ESG companies look good in theory, relying on ethical governance and adherence to ESG standards set by their management. Investors interested in ESG stocks should research the company’s statements about ESG to ensure they are operating within guidelines.
From there, investors should research to find the best investments based on their investment goals and time horizon.