'Sustainable' funds outperformed the broad market in the recent correction

Two-thirds of all sustainable funds available in the U.S. finished in the top half of their respective categories, according to Morningstar.

  • By Ryan Vlastelica,
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Being green may have prevented some red for U.S. stock investors in the recent downturn.

So-called sustainable funds — which tilt an equity portfolio toward companies with high scores on environment, social and corporate governance (ESG) issues — tended to perform better in the equity-market volatility seen earlier this month, according to a Morningstar analysis. While the funds fell alongside the broader market, a tumble that took both the Dow (.DJI) and the S&P 500 (.SPX) into correction territory, the losses were in many cases less severe.

In the first nine days of the month — a period over which the S&P fell 7.2% — two-thirds of all sustainable funds available in the U.S. finished in the top half of their respective categories. For equity funds, "65% outperformed their peers, with more than twice as many finishing in their category's top quartile than in the bottom quartile," wrote Jon Hale, head of sustainability research at Morningstar. Per his data, 30% of sustainable stock funds finished in the top quartile of their category, compared with the 14% that ended in their group's bottom quartile.

"Among the 37 sustainable offerings in the U.S. large-blend category, 26 finished the period in the category's top half," he wrote. "Not only that, but 30 of the 37 funds in the group outperformed the S&P 500." He added that "I didn't find a single broad-market sustainable index fund or quasi-index fund that underperformed from Feb. 1 through Feb. 9."

While examining fund performance over such a short period of time can be misleading — as Hale noted in a report — it bolsters the idea that focusing on such investment themes can generating alpha, or outperformance over a benchmark, in addition to being a way for investors to express their moral views through their holdings.

"While sustainable funds pursue a range of investment strategies, a common element among them is that the consideration of ESG factors leads to a preference for companies that manage material environmental and social issues effectively and have strong corporate governance practices," Hale wrote. "These tend to be higher-quality companies that hold up better during market turbulence."

Another factor for the recent outperformance: ESG funds tend to be underweight on traditional oil and gas energy companies, which have been among the biggest losers thus far this year, as oil prices have struggled.

ESG funds have seen higher demand over the past few years, and President Donald Trump's environmental policies — including pledging support for the coal industry and withdrawing the U.S. from the Paris climate accord — have been credited as a factor behind their popularity as investors use them to counter an administration they see as hostile to environmentally friendly policies.

However, the use of ESG funds is dwarfed by the popularity of passive index funds, which simply track the performance of underlying indexes by holding the same components the index does, and in the same proportion.

Passive funds have even gotten into ESG advocacy, as major passive fund providers — including Vanguard, State Street, and BlackRock — push for companies to improve their scores on ESG metrics. Vanguard has called for better climate-change disclosures and more diverse corporate boards, following State Street, which in July voted against the reelection of directors at 400 companies, citing gender diversity issues.

"There is compelling evidence that boards with a critical mass of women have outperformed those that are less diverse," read an open letter published by Vanguard in September. "Diverse boards also more effectively demonstrate governance best practices that we believe lead to long-term shareholder value. Our stance on this issue is therefore an economic imperative, not an ideological choice."

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