SRI indices that track the European and Japanese stock markets show less dramatic diversions from their unscreened cousins, but the differences that are there tend to work in their favour performance-wise.
ESG momentum
SRI screening does not need cost investors performance. Quite to the contrary. “The main message is that SRI is not a hindrance to performance,” says Walsh. And what even could help to further improve the return enhancing credentials of ESG-screening, is to encapsulate ESG momentum. Academic research suggests that ESG momentum, or the speed by which a company is improving, or indeed regressing its ESG credentials, is a powerful predictor of future performance.
This has led MSCI to launch an index that targets ESG momentum earlier this year. “Stocks that are rapidly improving get overweight, so the index catches the momentum factor as well,” says Doole. And stocks that see their ESG scores deteriorate get an extra underweight.
We can’t yet say with certainty whether ESG-screened indices will continue to outperform in the future, as we haven’t been through a full market cycle yet since ESG trackers arrived at the scene. But at least the signs are hopeful. And, says Morningstar’s Dutt: “Introducing a SRI-filter can improve corporate governance practices around the world.”
Sceptics may still place question marks at the inadvertent allocation bets some of these trackers make though. Especially the extreme underweight to China, the world’s second largest economy with a rapidly widening influence, may be problematic to investors.
However, as the Chinese economy matures, attention for better governance, respect for workers’ rights and for the environment should grow too, which may solve the problem over time.
And even SRI indices continue to exhibit strong divergence with their plain vanilla peers, that may not necessarily be a problem: “Investors who adopt SRI indices aren’t typically the ones most sensitive to tracking error,” says MSCI’s Doole.
