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Originally Posted On: https://www.equities.com/impact-investing/esg-conscious-investors-are-more-insulated-from-the-stock-markets-wild-swings/

ESG-conscious investors are more insulated from the stock market’s wild swings

Stock markets around the world have been whipsawed this week with sharp declines on Monday followed by a solid rebound on Tuesday, all in response to Friday U.S. jobs numbers which indicated a marked slowing in the world’s No. 1 economy.

That kind of volatility can spook investors, sending them running for safety. But conventional wisdom argues for long-term investors to stay the course with their financial plan in such circumstances, and that might be particularly good advice for those who have constructed portfolios aligned with ESG principles.

A number of studies in the last two years have shown that portfolios created to produce low ESG risk can also insulate investors from some of the worst effects of market volatility.

“In short: Portfolios with low ESG risk typically display better raw and risk-adjusted returns than portfolios with high ESG risk — and they have a better ability to withstand financial crises,” according to a Morningstar Sustainalytics study from April.

Although there is no reason to believe the recent stock-market turmoil will lead to another financial crisis, investors may be asking themselves “what would happen to my portfolio if markets suffered some historical-type events?”

To answer that question, Morningstar Sustainalytics’ analysts used the Morningstar Direct Scenario Analysis tool, which shows how one or more funds or portfolios would perform if conditions from a past market event were to recur. They used the tool to run a series of stress tests on ESG-constructed portfolios during three past crises: the 2007-09 subprime crisis, the 2010 Greek crisis, and the 2011 U.S. debt ceiling turmoil.

“In all regions, the lower ESG risk portfolios commonly had better return performance,” the study found. “This is likely because the factors common to the lower ESG risk portfolios regarding volatility, financial health, valuation uncertainty and economic moat generate downside protection under these more negative economic scenarios.”

In May researchers from the department of accounting and finance at the University of Auckland in Auckland, New Zealand, got similar results in looking at the impact of the COVID-19 pandemic on the global economy. The paper by Davood Askarany and Yinzhen Xin found the pandemic heightened corporate awareness of risk management, and ESG risk in particular.

“Simultaneously, it has intensified investor scrutiny of environmental, social, and governance performance in shaping investment decisions,” they said. “That has led (others) to posit that robust ESG performance acts as a mitigating force against stock crashes, volatility and market risk.”

Japanese researchers writing in an Economic Society of Australia, Queensland, journal article in June 2023 also found that ESG investing was a stabilizing force in the pandemic.

“The results of the study show a positive association between corporate ESG performance and stock returns during the COVID-19 period,” authors Lian Liu, Naoko Nemoto and Changrong Lu wrote. “Furthermore, strong ESG performance contributed to enhanced stock market stability and increased market liquidity in Japan during the COVID-19 pandemic.”

The authors concluded that their results “provide a rationale for implementing supportive measures and regulations that encourage companies to adopt and disclose robust ESG practices. By doing so, they can contribute to the stability and liquidity of the stock market and fostering sustainable economic growth.”

And a working paper from the European Central Bank in November 2022 found that stock investors weren’t the only ones getting a boost from ESG — bond investors receive benefits as well.

Because ESG bond investors are less likely to bolt at the first sign of negative performance, researchers said the likelihood that managers of less liquid funds would be forced to unload assets at fire-sale prices was reduced. That, in turn, “may be beneficial for the green transition, as it ensures a stable source of finance also in periods of high uncertainty and market volatility.”