The complexities of assessing performance from responsible investment strategies have been laid bare after Morningstar’s ESG indices delivered a mixed bag in 2023.
In calendar-year 2023, 44 per cent of Morningstar’s sustainability indexes outperformed their non-ESG equivalents; an improvement on 27 per cent outperformance in 2022 but a fall from 57 per cent in 2021.
Investors who chose to shun the carbon intensive energy sector last year were rewarded with climate and net-zero aligned indexes reporting a strong year, with 67 per cent outperforming their broad-based benchmark.
Robert Edwards, Director of Product Management, EMEA and ESG Indexes at Morningstar, says tilts away from the energy sector and toward technology and consumer cyclicals were the main drivers of the outperformance in these indices.
“Climate indexes, such as those focused on net-zero alignment, had a bounce back year, helped by above-market exposure to the technology sector. These indexes also benefited from tilting away from high carbon intensive sectors, which underperformed in 2023,” he says.
However, indexes focused on best-in-class security selection – which select the lowest ESG Risk stocks within a sector – generally performed poorly in 2023.
Edwards explains this underperformance resulted from avoiding the top-performing so-called “Magnificent Seven” stocks.
“Meta and Alphabet were left out of the Morningstar Global Sustainability Index because of ESG controversies, while Tesla and Amazon were excluded because of relatively high ESG risk within their respective sectors,” Richard says.
Data collection and privacy issues have long seen Meta – formerly Facebook – perform poorly in ESG ratings – it is currently considered high risk by Sustainalytics. Meanwhile Alphabet – the parent company of Google – faces class action lawsuits for misusing personal information and is ranked medium risked by Sustainalytics.
Tesla, the electric vehicle manufacturer and darling of the green transition, is accused by a group of 17 investors holding a combined USD1.5 billion of Tesla stock, of poor human capital management, including reports from workers and regulators that “point to a toxic culture at Tesla factories” which triggered multiple lawsuits alleging racial discrimination, sexual harassment, hostile work environments and anti-union activity.
Finally, Amazon.com is classified as high risk by Sustainalytics and is a poor ESG performer in its sector, which leads to it being excluded from or heavily down-weighted within most ESG-Risk-based indexes.
Edwards says: “Security selection and the exclusion of high-performing technology and communications stocks because of ESG screens explains much of the underperformance for the sustainability indexes in 2023. In the Morningstar Global Markets Sustainability Index, above-market exposure to stocks like Microsoft and Nvidia boosted performance returns but could not make up for missing out on Tesla, Alphabet, and Amazon.”
The challenge that such mixed performance brings to responsible institutional investors is how to balance a commitment to every part of ESG, while still honouring performance promises to their beneficiaries.
For example, the Morningstar Sustainability Tilt indexes aim to minimise portfolio-level ESG risk while delivering diversified exposure similar to their parent indexes, the Morningstar Global Markets indexes. The tilt indexes exclude companies exposed to tobacco, controversial weapons, and civilian firearms, as well as severe ESG-related controversies and companies out of compliance with the United Nations Global Compact. But in making such exclusions, as evidenced by the omission of Magnificent Seven stocks in 2023, can be detrimental to returns. Meanwhile excluding high-carbon emitting stocks proved beneficial.
Consequently, despite outperformance from some sustainable investment indexes, investors still have much to think about when it comes to balancing the need to do good with meeting their fiduciary duty.