ESG Spending: Do ESG Stocks Outperform? Environmental, social, and governance (ESG) investing has become increasingly popular in recent years as more companies adopt ESG standards. This new investment class comes with the question of performance. There...

Environmental, social, and governance (ESG) investing has become increasingly popular in recent years as more companies adopt ESG standards. This new investment class comes with the question of performance.

There is much debate as to whether ESG stocks outperform the market as a whole or not. Here is what investors should understand about measuring the performance of these investments and the difficulty in determining if they outperform or underperform the market.

Key Takeaways

• Companies are moving to an ESG model as a long-term way to improve investor returns.
• Some companies use the ESG label even though they do not follow principles the everyday person would call environmentally or socially responsible.
• The results for ESG stocks are mixed, as are the results of 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 try to promote social responsibility.

Prioritizing these issues results in a company that pays more attention to its operations at all levels and is governed by more sustainable principles. In theory, this careful governance creates better returns and higher profitability, leading some investors and experts to conclude ESG stocks should naturally outperform the stock market.

This theory is unproven because investors are paying a "Greenium" due to 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 with really defending or countering this theory is that ESG stocks have performed better in some countries than others.

Research has shown that some companies that are supposed to engage in ESG practices ignore these principles when it risks cutting into their profits. This has led to widespread skepticism that underperforming companies will talk about ESG for good publicity but set those principles and practices aside to ensure their own survival.

It's also theorized that an underperforming company will claim to adopt ESG principles to attract attention and money from investors.

But not all companies that adopt the ESG label are underperforming and looking for a boost. The companies behind some of the most well-performing ESG stocks are major corporations with nothing to lose by shifting to the ESG model.

Brief History of ESG Investing and Controversy

Some experts trace the roots of ESG investing back to the 1960s when concerns over social and environmental issues, such as civil rights, gender equality, and environmental pollution, began gaining traction. However, it took until the 2000s for ESG investing to really enter public discussions of institutional and individual investing.

ESG issues were first officially mentioned in the United Nations' Principles for Responsible Investment (PRI) report in 2006. This led to portfolios incorporating ESG criteria into their evaluations of companies for the first time.

Over time, the increasing demand for ESG-related company values from investors led to unique indices, such as the MSCI ESG Leaders Index and the S&P 500 ESG Index. These indices are meant to gauge whether or not companies are meeting ESG criteria across various sectors.

Despite the growing popularity of ESG investing, it has also faced significant opposition and skepticism. Some critics have argued that the focus on ESG factors could lead to a misallocation of investments, as money is diverted from companies with sound fundamentals towards those that meet ESG criteria.

Other opponents have argued ESG investing can result in reduced diversification and potentially lower returns, as investors exclude entire industries or sectors from their portfolios based on ESG concerns.

Moreover, there is an ongoing debate over the reliability and consistency of ESG data, as different ESG rating agencies employ different methodologies. This can lead to different rating agencies giving 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 typically low-risk. The companies behind them adhere to government regulations that affect their operations and are less likely to get involved in lawsuits.

This type of conscientious governance also attracts talent looking to use their skills to make the planet a better place to live.

Investors feel that ESG values provide a company with a solid operational foundation and focus on delivering steady returns. These stocks are excellent for long-term hold strategies as they'll perform better over an extended period.

Understanding the Greenium

Semi-rational preferences and emotions often play a role in an investor's decision to buy stocks. One investor can decide that they only want to put their money into ESG stocks because they feel that alternative energy and social awareness will help corporations survive a paradigm shift.

Meanwhile, another investor may think that brown energy, such as coal, oil, or natural gas, is stable and reliable in terms of investment returns and longevity even though its usage is in the early stages of being phased out.

As investors start to consider and buy green energy stocks over brown for investments, they're willing to pay more for the stock, even though its value may be deceptive. Hence, the Greenium.

Greenium plays a role in an ESG stock's value due to 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.

Therefore, buying an ESG stock today may not return value tomorrow if a company doesn't have its fundamentals in order. This puts investors at risk of losing money on their investments. Investing always has risks, but ESG stocks may or may not increase those risks due to 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 rated at CCC or B is considered a laggard, BB, BBB, or A is average, and AA or AAA are leaders in ESG standards.

According to the MSCI ESG ratings, some of the stocks that have been outperforming in recent months include Best Buy, Microsoft, Adobe, Intuit, and Nvidia.

There are mixed results when companies put the ESG theory to the test, and recent stock market losses distort how well ESG stocks are actually performing.

Investors must remember that we are still in a high inflationary period, even if inflation is cooling off. When you factor in higher interest rates, technology stocks usually underperform.

The MSCI USA Extended ESG Select Index has outperformed the MSCI USA Index four times in the past seven years, with one year having the same return.

Comparing the MSCI USA Extended ESG Select Index to the S&P 500 Index, the MSCI USA Extended ESG Select Index outperformed the S&P 500 Index in all but one of the last seven years. In 2022, the S&P 500 declined by 19.44%, while the MSCI USA Extended ESG Select Index declined by 21.12%.

This does not mean all ESG investments outperform the stock market. There are mixed results when looking at a few mutual and exchange-traded funds. For example, iShares MSCI USA ESG Select ETF (SUSA) underperformed the S&P 500 Index for the previous year.

Overall, the data is mixed enough to make it inconclusive if ESG outperforms the overall stock market. As a result, investors need to do their due diligence in determining the best ESG investments for their portfolios.

FAQs

Q: What are ESG stocks?

A: ESG stocks are shares in companies that exhibit strong Environmental, Social, and Governance (ESG) performance. These companies are typically more environmentally responsible, demonstrate good labor and human rights practices, and maintain robust corporate governance structures.

Q: Do ESG stocks outperform the stock market?

A: ESG stocks have shown mixed performance relative 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 may vary based on the time horizon, sector, and region.

Q: How can I identify ESG stocks?

A: ESG stocks can be identified by reviewing ESG ratings from agencies like MSCI. Ratings assess companies based on their ESG performance. You can also consult 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: Like any investment, ESG stocks carry inherent risks. However, ESG stocks may mitigate specific risks associated with environmental, social, and governance issues that could adversely affect company performance. It's crucial to maintain a diversified portfolio and consider various factors, including ESG-related policies when making investment decisions.

The Bottom Line

ESG companies look good in theory, relying on ethical governance and compliance with ESG standards set by their management. Investors interested in ESG stocks need to investigate the company's statements regarding ESG to ensure they are operating within the guidelines.

From there, investors need to research to find the best investments based on their investment goals and time horizon.

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