Far from country bets, crowding or overfitting, so-called "dark green" ESG indices have displayed outperformance across regions and over time. These indices have also exhibited clear signs of risk reduction in volatile market conditions. While the focus on higher ESG ratings at an index levels has delivered excess returns especially in Emerging Markets, which fits nicely with academic theory, many of the drivers of outperformance have tended to be more structural.

Looking at "dark green" ESG index rules, there are two main construction pillars: exclusions, based on activity involvement and controversies and inclusions, based on ESG rating classification criteria. We consider these two pillars as complementary generators of potential excess returns. This view is also widely supported by academic research. The exclusion approach provides more macroeconomic and single-stock stability thanks to structural shifts in the benchmark while the inclusion pillar generates financial outperformance, notably on the back of shifts in the style footprint. Given these different ESG dimensions, it is therefore difficult to pinpoint ESG outperformance to simply "one factor".


With the benefit of hindsight, the resilience of ESG indices during the COVID-19 crisis has only been a continuation, and to some extent an acceleration, of an existing dynamic at play. However, many investors and practitioners are divided as to whether the performance of ESG indices is due to herding effects, to sector biases, avoidance of tail risks or actually to the financial strengths of higher ESG rated companies.

This paper uses performance and risk attribution techniques over the 2015 to 2020 period. The analysis is based on historical index holdings and ESG data which are used to examine the causality of potential sources of outperformance of ESG indices in the Equities space. We selected the MSCI Low Carbon SRI Leaders indices (thereafter, "LCSL") as a representative "dark-green" ESG index, which in our view, strikes a balance between broadly-inclusive, low tracking error indices with minimal exclusion rates in controversial activities and fairly excusive, bottom-up indices with high concentration/ tracking error risk and reduced concept portability in single countries.

ESG performance: a behavioural analysis

The COVID-19 crisis stands out since it captures environmental, social, and governance aspects alike. While LCSL ESG indices were not spared from sizeable drawdowns in 2020, they proved to be considerably more resilient than their non-ESG counterparts. In fact, we find strong evidence of a superior risk return trade-off for ESG indices – an important driver for ESG adoption among less ESG-savvy investors. For all markets covered in this paper we find evidence of solid downside protection: COVID-19 related drawdowns were 30bps and 90bps less for the LCSL ESG versions of MSCI World and EM, respectively. For Japan (290bps) and Europe (210bps) we find even stronger evidence.

Nevertheless, when looking at year to date performance for ESG indices vs. their non-ESG counterparts, it could be seen that drawdown reduction alone does not explain the full performance picture. In fact as of the end of November 2020, year-to-date performance differentials between ESG and non-ESG indices are larger than the drawdown differences might suggest – pointing to a more pronounced recovery from ESG indices. Looking at the last five years, a timeframe across which ESG quality is comprehensive and reliable, it could be seen that both elements, namely risk reduction in periods of drawdown, and wider equity market outperformance are not unusual. Rather 2020 marked a continuation of existing trends which ESG strategies had displayed during the bull-market leading up the COVID-crash[1].

Cick here to read the full article

1. For example, when comparing the Sharpe ratio across World, its major building block, Europe, US and Japan, as well as Emerging Markets, we find that ESG-strategies provide superior risk-return combination across time and across regions compared to their non ESG index across the 5Y horizon

font

CIO View