Limit downside with 'good' funds

But now some ESG funds take different approaches, for example, their managers might allocate more to companies that score well in terms of ESG criteria – rather than exclude those that do not. And ESG funds have grown in popularity not just because of increasing demand for more ethical options, but also because of evidence that these funds do not return less than traditional funds that choose stocks purely for their return potential.

ESG funds have done well over the past few years in the strong global equity bull market but as many of these are relatively new their performance in a downturn has not been fully tested. However, some analysts argue that ESG funds' focus on 'good' companies may provide a defence when investors need it most. ESG funds could be more defensive during increased volatility and bear markets because companies that have a better record in terms of their environmental impact, are conscious of the social cost of their business and are well governed, should carry less corporate risk.

There are numbers to support this. The MSCI World and MSCI All Country World indices have seen maximum losses of 7.07 per cent and 6.81 per cent over the past 12 months. However, the MSCI World ESG Universal and MSCI All Country World ESG Universal indices have made lower losses of 6.95 and 6.73 per cent over this period respectively. The ESG indices have also been less volatile. However, these indices only launched last year so do not have a long track record.

"Companies that are forward thinking and take an ESG-conscious approach are likely to be more in demand in a more difficult climate," says Gavin Haynes, managing director of wealth firm Whitechurch Securities. 

Gary Waite, a portfolio manager at wealth manager Walker Crips, adds: "If you have a fund that holds good businesses, which are also held by large shareholders who are invested for the long term rather than short-term returns, it could help to insulate you from short-term downturns."

And many of the methods used by ESG funds, whether negative screening or weighting towards companies that with better ESG qualities, can be financially rewarding, argues John David, head of investments at ESG specialist Rathbone Greenbank Investments.

"More robustly screened ESG-based funds may have a focus on companies offering goods and services that are genuinely needed by society, and therefore more resilient to cuts in consumer, corporate, or state spending," he explains.

Cuts in spending could be a trigger or result of lower economic confidence, a situation that tends to go hand in hand with more volatility or difficult stock markets.

"It could also be argued that stocks that do well in terms of ESG criteria are likely to be held more widely by investors with a longer time horizon, and therefore less prone to selling at the first sign of a turn in markets," adds Mr David.

And companies that consider ESG factors may make better corporate decisions, resulting in better returns and protection against losses.

"[An ESG] filter can act as a buffer and help with risk protection," says David Harrison, manager of Rathbone Global Sustainability Fund (GB00BDZVKD12). "There are numerous examples of where a poor grasp of environmental issues and weak governance have destroyed significant value for shareholders."

Investors have been stung when companies have been hit by costs as a result of governance, environmental or social failures, for example, when Volkswagen (VOW3:GER) was caught cheating in emissions tests. So funds which consider ESG factors when choosing shares are likely to avoid or not heavily invest in such companies, and instead focus on higher quality companies should should fare better.

"There also increasing evidence a well-positioned business in terms of ESG can drive higher revenues," continues Mr Harrison. "This helps drive better visibility of earnings and cash flow. And a company with a more dependable earnings stream and enhanced earnings power should fare relatively well in more volatile markets."

When being good doesn't protect

However, ESG-focused equity funds may also actively screen out some of the most defensive companies. For example, tobacco and armament companies are considered to be non-cyclical because their revenues and share prices tend not to fall as much as the wider market in economic downturns. Over the past 15 years, if you had bought and sold MSCI All Country World index at the worst possible times you could have made a loss of 28 per cent. But if you had bought and sold MSCI ACWI Tobacco index at the worst times you would have lost 16.5 per cent.

And some ESG funds may fall more than broad market indices in a general bear scenario because they focus on smaller companies.

"In a general bear market where sentiment across the whole industry is negative, [an ESG fund's performance] will depend on its stock composition," says Andrew Gilbert, investment manager at wealth manager Parmenion. "Many large-cap stocks, which are more defensive in nature, are screened out, so you tend to have more small- and mid-cap stocks in ESG portfolios. These can fall more than large caps in a bear market, so you could have greater downside in that scenario. We only invest in funds with managers that have strong downside focus."

Lewis Grant, co-manager of the Hermes Global Equity (IE00B3FPGZ77) and Hermes Global Equity ESG (IE00BKRCPS19) funds, says you should pick the right type of ESG funds if you want them for downside protection. Funds that use exclusion approaches may offer less protection.

"If you exclude things such as tobacco you're actually giving [a fund] a higher correlation to market volatility," he explains. "I am totally on board with excluding tobacco for sustainability reasons but these companies have historically been very defensive."

Mr Haynes adds that ESG funds' performance depends on what is driving the market, so could lag if it is being driven by sectors such as oil and gas, and mining. And they could also fall more than the wider market if a downtown is focused on consumer or technology stocks, or newer industries where ESG integration is more prominent.

ESG funds also tend on average to be more expensive than traditional equity funds. Many ESG funds are smaller because they are newer, and smaller funds often have a higher ongoing charge because their costs are spread across fewer investors. The management teams of some of ESG funds also spend time engaging with companies they invest in which adds to expenses, and screening and applying ESG analysis also takes time and money.

ESG funds for downside protection

There are many ESG funds available to private investors. If you want ones that could limit downside it is probably better to invest in those that weight their allocations to companies with strong ESG credentials, rather than ESG funds that totally exclude companies and sectors. Funds that take the former approach should also have fewer sector biases.

Mr Gilbert says defensive ESG fund managers should be judged on their performance and ability to mitigate downside. You should also look at a fund's ESG policy to ensure it matches your criteria, as each asset management company has a different definition of what constitutes ESG, in particular in the way it applies it to ethical funds.

Janus Henderson Global Sustainable Equity Fund (GB00B71DPP64) picks companies of which the products provide a positive contribution to the environment or social change, in areas including clean energy, efficiency, environmental services and health. It uses an exclusion strategy as well as weighting and picking stocks according to their impact. It has around 37 per cent of its assets in technology stocks, its largest sector weight.

The fund has beaten MSCI World index and the Investment Association (IA) Global sector average over one and three years. Over the last year it has done this with less downside risk, and a lower maximum loss and maximum drawdown than this index.

Janus Henderson Global Sustainable Equity has been managed by that firm's head of socially responsible investing, Hamish Chamberlayne, since 2013 and was launched in 1991. It has an ongoing charge of 0.84 per cent.

Stewart Investors and parent firm First State have built up a reputation for being defensive, and holding well-governed and responsible companies for the long term. So while Stewart Investors Worldwide Sustainability Fund (GB00B7W30613) can lag in bull markets, it has produced a lower volatility, lower maximum loss and a lower maximum drawdown than MSCI World index over three years. It has also has beaten this index over three years, but lags it over one and five.

The fund has been managed by David Gait since 2012, and Nick Edgerton since 2014, who invest in companies that manage sustainability risks or have a positive impact on the sustainability of the economy. They also screen out companies that do not meet their ESG criteria.

Stewart Investors Worldwide Sustainability has an ongoing charge of 0.99 per cent.

Kames Global Sustainable Equity (IE00BYZJ3441) invests in companies that its managers, Craig Bonthron and Neil Goddin, consider are improving in terms of sustainability or are becoming ESG leaders in their sector. Unlike many other ESG-focused funds, it invests in emerging markets.

The fund holds 41 stocks and has a bias to mid-cap stocks, which account for 54 per cent of its assets. Since launch in 2016 the fund has made a maximum drawdown of 8.37 per cent, compared with 9.12 per cent for MSCI AC World Index. Over the same period, it has returned 51 per cent, versus 43 per cent for the index and the IA Global sector average of 40 per cent.

The fund has an ongoing charge of 0.96 per cent.

F&C Responsible Global Equity (GB0033145045) has been run by Jamie Jenkins, head of responsible global equities at BMO Global Asset Management since the beginning of 2014 and Nick Henderson since 2016. They pick stocks according to ethical criteria, using screens to remove unsuitable companies from their potential universe of investments. Since Mr Jenkins started running the fund it has scored a downside risk of 12.64 per cent, lower than MSCI World index's 14.22 per cent. Downside risk is a measure of the likelihood of a fund's return being below what it is expected to be. 

Over the same period the fund has returned 82 per cent, compared with 76 per cent for the index and the IA Global sector average of 61 per cent.

The fund has 24 per cent of its assets in technology stocks, 19 per cent in industrials and 18 per cent in financials. It has an ongoing charge of 0.8 per cent.

Fund performance

Source: FE Analytics as at 16.07.18, *three-year figures since launch on 21.04.16