Paper 1

Introduction: ESG positive funds outperformed globally over 5 years but had a rough year in 2022, especially in comparison to their benchmarks in US markets. The exclusion of certain industries from ESG funds led to opportunities, as demonstrated by the performance of oil and gas companies in 2022. The following paragraphs explain the recent performance of US ESG funds, examine the impact of environmental factors on returns, and explore the effect of industry exclusions.

ESG funds performed worse than the market, irrespective of their carbon intensity. Past data suggests that ESG portfolios that were tilted towards environmental assets performed better in US markets. According to data (2017-2022) taken from “ESG Book”, environmental-postitive portfolios outperformed their benchmark index in the US by 0.28%. Meanwhile, portfolios with a focus on enhanced social indicators experienced a -1.29% deficit in comparison to their benchmarks, implying that environmental and social factors present a mixed impact on returns within the US market. Examining MSCI indices, the MSCI ESG Leaders Index outperformed its parent index globally, across Europe and developing economies. Notably, in recent years, the only geography where the index underperformed the parent index was in the USA. However, for the MSCI USA Low Carbon Leaders Index, returns remained comparable, further emphasizing the pronounced role of carbon-intensity for returns in the US market. The subsequent graph depicts the excess returns of US ESG funds concerning the S&P 500 within the investigation period from January 2022 - February 2023. The data suggests that in this period, ESG funds performed worse irrespective whether they were focused on optimizing their carbon intensity, such as the Paris-Aligned Climate MSCI USA ETF (“PABU”) or not.

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ESG funds faced additional headwinds in 2022 because they benefited less from high oil and gas prices. Large and mid-cap US ESG funds such as “ESGU” broadly replicate indices such as the S&P 500. In fact, ESGU encompasses only 35 holdings not featured in the S&P 500, thereby rendering it vulnerable to market downturns. While several companies struggled in 2022, fossil fuel enterprises thrived due to escalating oil and gas prices. These entities are likely excluded from ESG funds, considering their environmental impact. The subsequent graph showcases the excess returns (blue) of ESGU when compared with the S&P 500. The light blue line denotes a smooth trend line, whereas the red line depicts the excess returns of the IEO, a US-based oil and gas exploration and production fund. The graph delineates that ESG funds performed exceptionally against the S&P 500 from 2019 - 2021; however, their performance declined from around 2021. Conversely, the oil fund’s excess returns concerning the S&P 500 moved in the opposite direction, potentially due to escalating oil and gas prices linked to supply chain disruptions in 2021 and Russia’s invasion of Ukraine in 2022.

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Besides oil companies, ESG funds also usually don’t contain defense stocks, Aerospace stocks and tobacco stocks – but some of those companies had a better year than the market. There are 226 companies which are exclusively in the S&P 500 but excluded from ESGU. The subsequent graph delineates the top 10 companies within this cohort. Consumer staples such as Walmart, Philip Morris, and Altria Group typically evince greater stability in volatile markets, while Lockheed Martin and other defense enterprises profited from Russia’s invasion of Ukraine, which catalyzed renewed demand for defense systems.

Conclusion: The underperformance of ESG funds in recent times can be attributed to various factors, including exogenous shocks like supply chain disruptions caused by the Covid pandemic and the war in Ukraine, which led to a volatile market environment in which certain stocks excluded from ESG funds performed relatively well. Nevertheless, the long-term outlook for ESG investing remains positive, as climate change and other environmental and social issues continue to dominate the public discourse. As the markets eventually calm down, investors are likely to keep ESG funds on their minds, considering their potential to offer both financial returns and a positive impact on the environment and society.