ESG Index Funds Are Outperforming (Mostly)

Morningstar’s environmental, social, and governance indexes are beating the market across most countries and categories — but less so in the U.S.

Qilai Shen/Bloomberg

Qilai Shen/Bloomberg

Here’s more evidence that environmental, social, and governance risks matter for investment performance.

Fund research firm Morningstar said in a recent report that its ESG-screened indexes — including broad sustainability indexes and those tracking specific categories like renewable energy — largely outperformed in 2020 and over the last five years, while also offering more downside protection.

Specifically, 75 percent of the Morningstar indexes beat their benchmarks in 2020, while 88 percent of indexes with a five-year track record outperformed over the second half of the last decade. Nearly all of those indexes — 91 percent — lost less than their broad market equivalents during downturns over the last five years, including during the recent coronavirus crash.

“While relative returns certainly shift, the downside protection demonstrated by the ESG indexes supports the notion that ESG risks are financially material,” Morningstar strategist Dan Lefkovitz wrote in a report on the results.

In the report, Lekfovitz noted that screens for ESG “have recently been more successful outside the U.S.” For example, among Morningstar’s 21 sustainability indexes — which select companies based on the firm’s Sustainalytics ESG ratings — the global markets index excluding the U.S. outperformed its large- and mid-cap equivalent by almost 3 percentage points last year, with five-year excess returns of 1.46 percent.

The U.S. sustainability index, meanwhile, underperformed by 2.9 percentage points in 2020 and 81 basis points over the last five years. Still, Morningstar said that the U.S. index was less risky than the larger market, capturing about 95.6 percent of the market downside over the last five years.

[II Deep Dive: What Happens When a Company Gets an A From One ESG Rater and an F From Another?]

Other losers in 2020 included Morningstar’s low-carbon indexes, which slightly underperformed last year everywhere except in emerging markets. Over the five years, however, the indexes have delivered slightly higher returns in most markets, and offered better downside protection in all of them.

Meanwhile, renewable energy indexes sharply outperformed last year, with Morningstar’s global index beating the market equivalent by almost 11 percentage points in 2020. Over the last five years, it earned an excess return of 2.26 percent.

Lefkovitz wrote that a “common assumption is that ESG screens have done well lately because they skew toward the technology sector, which has led the market, and away from energy, the biggest laggard.” However, he said the overall outperformance observed in Morningstar’s indexes was “not just about sector bias.” For example, the U.S. sustainability index underperformed “despite being heavier on technology and lighter on energy,” Lefkovtiz said.

“The recent risk/return record of Morningstar’s ESG indexes supports the view that sustainable investing need not entail a performance sacrifice,” he concluded.