Against the background of the Covid 19 crisis, ESG (Environment, Social and Governance) stocks proved to be a little less vulnerable than the rest of the universe. But there are many concurring ESG methodologies. Which ESG strategy is the most efficient in this specific context?
We here aim at comparing two major types of ESG selection strategies: one that presumes that all the economic sectors are at the same ESG level (the “best in class method”) with the one assuming that sectors intrinsically present heterogeneous ESG ranges (“best in universe”).
These two different ESG approaches are compared on the S&P500 (the United States stock market index encompassing the 500 largest US companies) and the Stoxx600 (made of fixed all-size capitalization companies among 17 European countries) universe. The ESG rating used is the Mirova ISS ESG rating, i.e. a proprietary scoring of Mirova (sustainability expert affiliate of Natixis Investment Managers) based on ISS ESG research.
The best in universe method provides a 1-month return 1% higher than the best in class method
The best in universe methods seems to outperform the best in class method in the sector analysis. Considering stock returns between February 24th, 2020 and April 1st, 2020, where February 24th registered the beginning of an increasing volatility (it is the date when the VIX index, the expected volatility measured on Chicago Board Options Exchange's S&P index options, exceeded 20%), we notice that the best in universe method presents a total mean return 1 point higher than the best in class method.
Why? Because the best in universe method tends to diminish the proportion of Oil & Gas stocks (which were hit by a decrease in transportation and the collapse in oil prices) and increase the proportion of Health Care stocks and Telecommunications, Software & IT Services, industries for which demand rose with the Covid 19 crisis and confinement. On the opposite, the best in class method keeps each sector’s representation equal to the in the basis universe, consequently offering a performance profile that is closer to the one of the global economy. In other terms, over the last month - where we saw the rise of the “essential products and services” redefinition - best in uiverse approach tends to offer a more robust answer.
Mirova ISS ratings to pinpoint inherent ESG sectorial rationale
ESG ratings comes from Mirova. Mirova re-scales ISS ESG (which ranges from 1 (D-) =worse to 4 (A+) =best) to a New Sustainability Score ranging from 0 (=worse) to 10 (=best). This rating assesses companies’ position (negative, at risk, neutral, positive, engaged) with respect to sustainable development goals. This evaluation relies on 4 major principles:
- A risk/opportunity approach: providing solutions and good practices regarding ESG risk management;
- Targeted and differentiates issues: focusing on a limited number of challenges adapted to each asset specificity;
- Life-product cycle: analyze environmental and social challenges from raw material extraction until products’ end of life;
- Qualitative and absolute evaluation: provide a qualitative opinion without any specific distributional presuppositions.
We worked with this specific Mirova ratings because this approach tends to favor sectors with an intrinsicly positive sustainabilty impact. Indeed, Mirova uses a scoring that enables to distinctively variegate ESG ratings with respect to sectors. And this highlights the inherent sectorial logic inside ESG considerations.
The stock universe used here is made of all the stocks rated by Mirova ISS ESG that are in S&P500 or Stoxx600 stocks. There are 1065 stocks in the Mirova ISS ESG universe that are also in S&P or in Stoxx600 indexes. This represents a little less than 20% of the companies rated by Mirova. We matched companies’ data via their respective ISIN numbers, and computed stock returns based on Bloomberg last prices for each stock, using rt1 = (pxt1 – pxt0) / pxt0.
The best in class method is applied to 2 specifications:
1) ICB industry as class (10 categories)
2) Sector as class (more granular with 49 categories)
It appears that best in universe is more efficient than best in class methods when we use sectors as classes. Using industries as classes gives tighter results.
ISS ESG Mirova Score analysis in the S&P500 + Stoxx600 universe
On the S&P500 + Stoxx 600 universe, Mirova ISS ESG score ranges between 0.78 and 9.92, with a mean at 5.01 and a median at 4.71. Mean return from Feb 24th, 2020 on the total S&P500 + Stoxx 600 universe is -27%. Both best in class and best in universe ESG selections are better performing by more than 1%.
When we use sectors as classes, the best in universe method presents a total mean return from February 24th, 2020 1 point higher than the best in class method (-24.37% for the best in universe versus -25.30% for the best in class method).
The industry-class analysis presents smaller return differences. When we use industries as classes, the best in universe method, presents a total mean return from February 24th, 2020 0.07 point higher than the best in class method (-24.33% for the best in universe versus -24.40% for the best in class method).
Click on legend to select displayed series & double click to isolate a series:
Relative ESG stock performance follows 2 opposite trends before and after the end of 2018.
Before the Covid19 crisis, the 20% worse ESG performing stocks are outperforming. From September 2018, this subset faces a severe decline.
During the Covid 19 crisis (second line chart presenting returns from February 24th, 2020), the 20% best performing ESG stocks (best in universe) is outperforming, and the 20% worst in class underperforming. While best in class and worst in class subsets (here with ICB industries as classes) provide similar returns, and both generally under the benchmark (S&P500 + Stoxx600) returns.
Europe versus US analysis
¾ of the best ESG rated stocks in the universe are European. In the industry analysis, out of the 209 best in universe stocks, 59 are in S&P500 (thus are American stocks), and 150 are in Stoxx600 (thus are European stocks). In the sector analysis, out of the 196 best in universe stocks, 58 are in S&P500, and 138 are in Stoxx600.
With the CIB industry approach, mean return as of February 24th, 2020 of the 59 S&P500 stocks among the 209 best in universe stocks is -18% versus -27% for the 150 Stoxx600 stocks. The numbers with the sectorial approach are very similar.
1) Analysis per ICB Industry
The best in class method selects best ESG ratings per industry or per sector, while the best in universe method selects the best ESG ratings on the whole universe.
There are 77.51% stocks in common between the best in class method and the best in universe method.
11 top ESG stocks are selected for the Utilities industry for the ICB industry best in class method. We see that this selection outperforms the universe by 2%: mean return from Feb 24th, 2020 for the top 20% ESG Score in the Utilities industry is -21%, while in the same period, mean return in the S&P500 + Stoxx600 Universe in the Utilities industry is -23%.
We see that the best in universe method tends to diminish the proportion of Oil & Gas stocks (that were hit by a decrease in transportation and the collapse in oil prices) and increase the proportion of Health Care and Telecommunications stocks, industries for which demand rose with the Covid 19 crisis and confinement. On the opposite, the best in class method keeps each sector’s representation equal.
2) Analysis per Mirova sector
There are 65.31% stocks in common between the best in class method and the best in universe method.
We see that the best in universe method tends to diminish the proportion of Machinery, Oil & Gas stocks (that were hit by a decrease in transportation and the collapse in oil prices) and increase the proportion of Software & IT, Telecommunications, Commercial Services & Supplies, as well as sectors linked to Pharmaceuticals, Biotechnology, and Health Care, sectors for which demand rose with the Covid 19 crisis and confinement. On the opposite, the best in class method keeps each sector’s representation equal.
Nevertheless, we can notice that with the best in universe method, the exposition to the Food & Beverages sector reduces by 50%. So, to get a proportionally higher share of Food & Beverages stocks, the best in class method seems to be better suited than the best in universe method. On the other hand, the best in universe method - selecting only stocks with highest ESG scores in this sector - may remain a better bet. In the long term distribution and supply chain will evolve and may benefit to the ESG leading actors. Indeed, consumers are longing to smaller supermarkets, local products, and attracted by small producers. This will advantage actors evolving in this direction. Thus, one can consider that the context does not invalidate the best in universe method for this Food & Beverages sector over the mid to longer term.