A harsh wind blows, but responsible funds set sail for calmer waters

Responsible funds show strong outperformance during the COVID-19 pandemic.

We are in the midst of the coronavirus pandemic and its impact is being felt around the world with no clear end yet in sight. As unemployment rises, spending slows, and citizens of many countries around the world are placed in lockdown, economic activity has plummeted. What does this mean for investors?

Economic shocks inevitably lead to volatility in traded securities and this time is no different. Since a record market peak on 20th February 2020, the ASX 200 has hit its lowest value in five years by 27th March 2020. Whilst we are now witnessing some bounce-back, the road to recovery will be a marathon, not a sprint.

And Australia is not alone in a sea of red ink, indeed the global selloff has spared no country’s stock market.

At an overall market level losses have been large, but it would appear pain is not being felt equally by investors. Some promising early signs point to the strong performance of responsible funds compared to mainstream funds and index benchmarks.

Responsible funds weather the storm
While we shouldn’t read too much into such a narrow time frame, early data suggests responsible approaches are paying off, or at least minimising the short term pain felt by many investors. Sustainable funds – that is funds with a focus on companies with strong ESG (Environmental, Social and Governance) credentials – have mostly outperformed their conventional counterparts across Q1 2020.¹

According to research conducted by Morningstar, 44% of US sustainable equity funds reported top quartile performance in their respective peer groups.

The story looks even better for funds investing outside the US. Globally, the MSCI World stock index fell by 14.5% in March, however, 62 per cent of global environmental, social and governance-focused large-cap equity funds outperformed the global tracker, according to data from Morningstar.²

Source: Morningstar - Full sector classifications: EAA Fund Europe Large-Cap Blend Equity; EAA Fund Global Large-Cap Blend Equity; EAA Fund UK Large-Cap Equity; EAA Fund US Large-Cap Blend Equity Base currencies: Global and US in dollars, UK in pounds, Europe in euros. All figures in percentage

There are many reasons behind this but as a recent Bloomberg report noted:

“Managers of sustainable funds have long said they can use ESG factors to limit risks in their portfolios. They are often heavily invested in technology and health-care stocks and they typically have little or no holdings in fossil-fuel companies, which have plunged in value. They tend to be underexposed to heavy-polluting companies such as cruise-line operators and airlines”.³

Debunking the performance myth
To the uninitiated, one question that has loomed over ethical funds - that of performance. Sceptics argue that applying non-financial considerations to the investment process — for example, ethical screens — must result in lower returns, as it reduces the number of investment opportunities. Could portfolios that avoid fossil fuels, armaments, and other profitable but controversial industries still achieve competitive returns? Furthermore, can they survive during times of market volatility?

The financial crisis coming out of the COVID-19 pandemic provides additional evidence to disprove the doubters. This selective approach to securities and sectors employed by responsible funds can work to de-risk investment portfolios.

Recent research from HSBC of 140 global companies with the strongest ESG profiles compared to peers across the period from 10th December to 23rd March, and from 24th February when the significant volatility began showed an outperformance of around 7% for both periods.

A focus on companies with strong Environment, Social, Governance (ESG) profiles and less exposure to energy is paying off. Companies that perform well on ESG criteria tend to be organisations that manage environmental risks, treat their stakeholders well, and govern themselves in a responsible way. Many such companies are proving to be more resilient during the sudden crisis in which we now find ourselves.

As U Ethical’s ethics and impact manager Georgina Laird explains;
“We believe that companies with a focus on non-financial risks, who give consideration to the long-term sustainability of their business model, are better placed to adapt to societal challenges. This time is no different. This contemporary crisis will bring more scrutiny than ever before on corporate social responsibility. Eventually, we will enter a period of reflection, and those more agile companies who reacted quickly and adapted well to ensure the well-being of their stakeholders will be rewarded.”

Responsible funds see record flows
The capacity of responsible funds to withstand a downturn have now been tested in times of uncertainty and turmoil, and they appear to be winning over more and more converts.
Outside of long standing ethical funds such U Ethical’s Australian Equities Trust, most of the growth of sustainable investing has taken place since the global financial crisis, much of it in just the past five years. That means few sustainable funds have been through the stress test of a bear market until now – and they’ve held up well.⁴

Morningstar noted recently,
“Despite the sudden descent of equities into a bear market halfway through the quarter, estimated net flows for the 314 open-end and exchange-traded sustainable funds available to U.S. investors reached $10.5 billion in the first quarter, easily eclipsing the previous quarterly record set in 2019's fourth quarter.”⁵

Source: Morningstar Direct. Data as at 31/03/2020

Should this growth continue, sustainable funds are on track to eclipse last year's mark, a formidable statistic considering the ongoing pandemic could still wreak havoc with fund flows for the rest of 2020.

This crisis is taking us all into uncharted territory, it remains unclear when a semblance of normality will return. Despite this, it is edifying to see the broad strength of ethical investing strategies and screening programs which prove once again that you do not have to sacrifice returns to invest ethically.

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Things you need to know

1. Past performance is not an indicator of future performance

2. ESG funds continue to outperform wider market”, Madison Darbyshire, 3 April 2020, https://amp.ft.com/content/46bb05a9-23b2-4958-888a-c3e614d75199

3. https://www.bloomberg.com/news/articles/2020-03-13/older-esg-funds-outperform-their-newer-rivals-in-market-tumult?sref=wINQCNXe

4. https://www.morningstar.com/articles/976361/sustainable-funds-weather-the-first-quarter-better-than-conventional-funds

5. https://www.morningstar.com/articles/977328/despite-the-downturn-us-sustainable-funds-notch-a-record-quarter-for-flows

Important Information
The market commentary reflects U Ethical’s position at the time of publication and is subject to change. U Ethical reserves the right to make any adjustments to the investment strategy or outlook for all products at any time to reflect major disruptions or changes in the financial markets, as allowed by the relevant governing documents, Product Disclosure Statement, Information Memorandum, or Offer Documents. Past U Ethical Funds performance is not indicative of future performance.

U Ethical, their affiliates and associates accept no liability for any inaccurate, incomplete or omitted information of any kind or any losses caused by using this information.

The information provided is general information only. It does not constitute financial, tax or legal advice or an offer or solicitation to subscribe for units / debentures in any U Ethical Fund of which U Ethical is the Manager, Administrator, Issuer, Trustee or Responsible Entity. This information has been prepared without taking account of your personal objectives, financial situation or needs. Before acting on the information or deciding whether to acquire or hold a product, you should consider the appropriateness of the information based on your own objectives, financial situation or needs or consult a professional adviser. You should also consider the relevant Product Disclosure Statement, Information Memorandum or Offer Document which can be found here or by calling us on 1800 996 888.