As we reflect on how the novel coronavirus (COVID-19) is affecting environmental, social, and governance (ESG) investing, I recall a quote from a pension fund representative who explained why he cares about solutions to climate change and income inequality. His perspective: The returns we need only come from a system that works. The benefits we pay are worth more in a world worth living in.
This point of view seems especially relevant today. We’ve seen many news articles about ESG funds’ performance during the COVID-19 pandemic, often making these two points:
- ESG funds were resilient in the first quarter, faring better than peers and the broad equity markets
- As companies take action to curb the pandemic’s effects, fresh thinking about what makes a company valuable could propel ESG investing forward.
Why are these stories proliferating? Are the pandemic’s effects causing investors to think ahead about how to shape a world worth living in? We think market participants are learning lessons about what they want from companies during and beyond the crisis, the fundamental role of business and society, and especially the pact between employers and employees.
The Coronavirus Aid, Relief, and Economic Security (CARES) Act stimulus program is designed in many ways to safeguard the American worker. And as COVID-19 wreaks havoc on our economy, we’re seeing news every day about firms taking dramatic steps to keep their doors open while preserving a core asset—their employees. These are positive developments. But let’s not lose sight of the bigger picture. What the headlines are reporting on is mainly short-term material:
- A quarter’s worth of ESG fund performance
- Current sentiment over companies’ actions
- Corporate initiatives that may or may not endure beyond the end of a government stimulus program
Just as investors should focus on the long term in how they view and manage their portfolios, we recommend looking at COVID’s effects on ESG through a long-term lens. And as we watch the pandemic’s effects unfold, we’re seeking clues to help us answer three important questions. Beyond the pandemic:
- Will companies’ focus on job protection and worker well-being endure?
- What does the resilient performance of ESG funds in the first quarter portend for the category?
- Will market participants seize the opportunity to design an economy that supports both the worker and the environment?
Will the focus on job protection and worker well-being endure?
Before the pandemic, 40% of Americans couldn’t cover an unexpected $400 expense without borrowing or liquidating assets, according to the Federal Reserve’s 2018 report on U.S. households’ economic well-being. Imagine how that situation escalates during a pandemic that’s putting millions out of work. Lockdowns disproportionately affect low-income workers, many of whom lack paid sick leave and must be physically present to perform their duties. Without a financial cushion to absorb a shock of this magnitude, they face tough choices. Paradoxically, by continuing to work, they place themselves at further risk.
In the hardest-hit industries like travel and tourism, most companies will be unable to shield all employees from the devastating plummet in revenues. In light of this, some companies are blending compassion with innovation to soften the blow. Consider the actions of Hyatt Hotels, whose industry is firmly in the pandemic’s crosshairs:
- For as long as possible, the firm will do furloughs instead of layoffs, so employees can access unemployment, yet retain health care and other key benefits.
- The company’s CEO and chair are not taking salaries, while the rest of the senior leadership team is taking a 50% pay cut. The company channeled these savings into a fund to support its employees who are most in need.
- To help its thousands of employees who are on furlough or who have lost their jobs, Hyatt is partnering with 10 other companies who are hiring, to help place its affected staff.
This is where the essential concept of human capital management (HCM) comes into play. On the long-term path to success, what does a company prioritize in terms of how it elicits productivity and loyalty from its workforce? Are the company’s people truly treated as its greatest assets, or is that a veneer that obscures efforts to squeeze workers for output? ESG investors have long advocated for actions oriented at health and well-being and shared financial success as signposts of strong companies.
In many respects, stimulus measures create space for tactics that otherwise would personify the concept of stakeholder capitalism, through which corporations act to address the needs of all their myriad stakeholders—beyond customers and shareholders to employees and local communities.
But, here’s the challenge. Groundswells of action that occur amid crises are susceptible to fading into a pre-crisis business-as-usual dynamic over time. A six-month guarantee that a company won’t lay off its workers might recede when the CARES Act’s requirements and incentives reach their end.
Imagine if this didn’t happen. What if, in the future, companies’ pandemic-era programs to support workers eventually become the norm? And investors at a widespread level assign value to companies, based on that high bar? As the government support eventually sunsets, we hope companies will internalize their employee commitments and assign a higher premium to human capital. The opposite scenario, in which companies essentially succumb to pressure to reduce costs and boost earnings by eroding these benefits, would be a missed opportunity for long-term value creation.
What does ESG funds’ resilient performance in the first quarter portend for the category?
On the whole, ESG or sustainable funds outperformed their peers in the first quarter, with their returns disproportionately in the top half and top quartile of their categories, as reported by Morningstar
(see Figure 1).
Prior to the pandemic-sparked market downturn, downside protection had been a selling angle for many ESG proponents, backed by the thesis that ESG analysis enhances the analytical perspective by scrutinizing more qualitative value drivers, helping identify superior managed or governed firms and fostering a long-term mindset. Given that many funds in the category were launched after the global financial crisis, the first-quarter bear market was a critical test.
Although the recent performance is welcome, the performance story is better told from a longer perspective. The picture is broadly similar. An August 2019 Morgan Stanley study of nearly 11,000 funds from 2004–2018 found no statistically significant difference in the total returns of sustainable funds compared with conventional peers, but 20% smaller downside deviation.*
Perhaps this performance reflects investor recognition that companies interact with a variety of stakeholders (in the present and the future) and that company behaviors towards stakeholders affect returns. After all, financial analysis tells you what a company has done, or will do in the short term (for example, accounts payables, interest cover), whereas ESG analysis illuminates unfurling systemic trends such as decarbonization or inequality and unlocks clues on how a company may adapt in the future.
ESG investing is clearly having a moment. Rather than descend investors’ priority list as the bull market ended, as some speculated would happen, it now garners more attention. We think this will invite scrutiny from discerning investors and regulatory bodies who want to look under the hood to substantiate investment manager claims about their ESG prowess. Investment managers must continue constructing and deploying robust frameworks to capture the beneficial investment insights that ESG research provides and to support client needs.
Will market participants seize the opportunity to design an economy that supports both the worker and the environment?
This is unlike any crisis in living memory. But like previous crises, the pandemic brings opportunity alongside destruction. As the situation begins to stabilize, business leaders (and policy-makers) will face a stark choice about the inevitable restart: revert to business as usual or align toward a new type of societal plan?
We are seeing a rebalancing in how ESG components are prioritized. Amid the focus on rescuing the economy and protecting workers, the social aspect is paramount. Unfortunately, companies’ amplified human capital practices will mean less in a future in which we’ve failed to stay on top of environmental concerns.
We’ve seen the news articles about how industrial activity’s grinding halt has provided some transient environmental benefits like cleaner air. But, one crisis does not forestall another. Atmospheric greenhouse gas concentrations continue to build, the physical risks of climate change continue to intensify, and—as our WFAM Climate Working Group has identified—the financial impact across global industries commands investor attention.
Before the pandemic radically changed life as we know it, blueprints for a sustainable, inclusive, and prosperous economy had begun to take hold—for example, the UN’s Sustainable Development Goals (SDGs). The SDG vision of a just and regenerative economy is not a luxury future. It’s a world worth living in and one we can’t afford to go without.
The pandemic shows the dangers of politics and hubris overshadowing science, and we feel it provides lessons on how we may overcome the climate crisis.
- Global thinking and coordinated action with strong sovereign, sub-sovereign and bold private sector initiatives must characterize a robust climate solution
- In parallel, this pandemic underscores many of the challenges exemplified in the SDGs, including good health and well-being; decent work and economic growth; and calling back to our earlier point about COVID’s effects on our economy’s most vulnerable in the transition to a low carbon economy, reduced inequalities.
To achieve a more just and greener future, now more than ever our collective efforts must have a vision and be intentional, far-sighted, and courageous. In light of this, we believe:
- Policy-makers must create the enabling conditions and necessary incentives.
- Companies need to fulfill their previous targets and up the ante.
- Investors must price these signals to prudently manage risk and allocate capital appropriately.
- Investors must also demand what they see as valuable.
Findings from the latest Wells Fargo/Gallup Investor and Retirement Optimism Index survey reveal significant opportunities for our industry to help investors learn about sustainable investing and align their investments with their values. To learn more, read our blog post about the survey results.
*Downside deviation is a measure of downside risk centered on returns that drop below a minimum threshold.
Chris McKnett is a senior ESG investment strategist for Wells Fargo Asset Management.
Stock values fluctuate in response to the activities of individual companies and general market and economic conditions. Bond values fluctuate in response to the financial condition of individual issuers, general market and economic conditions, and changes in interest rates. Changes in market conditions and government policies may lead to periods of heightened volatility in the bond market and reduced liquidity for certain bonds held by the fund. In general, when interest rates rise, bond values fall and investors may lose principal value. Interest rate changes and their impact on the fund and its share price can be sudden and unpredictable. Investing in environmental, social, and governance (ESG) carries the risk that, under certain market conditions, the investments may underperform products that invest in a broader array of investments. In addition, some ESG investments may be dependent on government tax incentives and subsidies and on political support for certain environmental technologies and companies. The ESG sector also may have challenges such as a limited number of issuers and liquidity in the market, including a robust secondary market. Investing primarily in responsible investments carries the risk that, under certain market conditions, an investment may underperform funds that do not use a responsible investment strategy.