The performance of environmental, social and governance (ESG) funds during the Covid-19 pandemic and their alignment with government visions in the GCC make them a compelling choice for investors in the Middle East, according to Aberdeen Standard Investments (ASI).

In the first quarter of this year, the Covid-19 pandemic prompted the most severe stock-market crash since the global financial crisis. But for investors who focus on ESG issues, there was some comfort to be found in the relative resilience of ESG funds.

In this turbulent period, companies with better ESG ratings have outperformed the broader market. This is true across all regions, and the outperformance is part of a longer trend.

For the Middle East, in particular, this bodes well for ongoing regulatory efforts to create standards and frameworks to ensure mandatory sustainability reporting. For example, in Abu Dhabi plans are underway at the Financial Services Regulatory Authority (FSRA)to introduce ESG criteria for entities within the Abu Dhabi Global Market (ADGM).

Meanwhile, the Dubai Financial Market, launched the UAE Index for ESG in mid-April 2020, creating the first benchmark in the region that will gauge the responsibility of listed firms in the United Arab Emirates (UAE).

More broadly, the official multi-year economic and strategic ‘visions’ in Saudi Arabia,Kuwait and the UAE already include a strong focus on sustainability, diversification and environmentally friendly practices.

The importance of such initiatives for local investors is ever-clearer given recent evidence of how ESG funds have performed globally – those funds that adopt some form of ESG strategy have outperformed traditional funds over the past five years.

And stocks that are in the top quintile of Sustainalytics’ ESG ratings have outperformed the S&P 500 since the fourth quarter of 2018 and have performed especially well, in relative terms, during the sell-off caused by Covid-19.

Edris Alrafi, Head of Middle East & Africa for ASI, said: “This is significant because the Covid-19 pandemic is by far the biggest market crisis that many ESG funds have faced. Most dedicated ESG strategies were launched after the 2008 financial crisis and so have been beneficiaries of the long bull market that persisted for more than a decade thereafter. Now, however, that bull market has come to a dramatic end. And ESG funds appear to have come through the crash in good shape.

“We should be cautious, though, in making any claims about this short-term performance – or in attaching any particular importance to it. After all, the essential attraction of funds that incorporate ESG factors is their focus on the long-term, through good governance and societal and environmental sustainability.

“The short-term outperformance of ESG funds may owe more to their sector positioning than the ESG credentials of their component stocks. For example, the plunge in the oil price, and the boost in the healthcare sector have been beneficial to most ESG funds.

“And the stocks that have held up best during the sell-off may not be prime beneficiaries of a rebound in investor sentiment. It is possible, for example, that heavily polluting companies and sectors will bounce back strongly as the recovery from the crisis gets underway – which would be to the detriment of more sustainably focused funds.

“Nevertheless, ESG and sustainability-tilted funds have consistently shown less vulnerability to downturns than traditional funds. This effect is particularly pronounced when markets have been especially turbulent – as in 2008, 2009, 2015 and 2018.”

Where ESG funds should demonstrate their potential more significantly is once the first phase of the economic recovery is complete. As many have noted, in the medium term, there is an opportunity to ‘build back better’ – establishing a cleaner and greener economy that is ultimately more sustainable.

This could entail a shift towards a ‘circular economy’, in which resources are not wasted and recycling is prioritised. Already, some governments are taking significant steps in this direction – as in the European Union, where there is agreement that the economic recovery should be consistent with the ‘green transition’, and in South Korea, where the government has announced a ‘green deal’ to stimulate the economy and target zero net emissions by 2050.

Edris continued: “Any moves towards a greener economy should reward the environmental focus of ESG funds. Companies that address social inequalities and adopt responsible business practices will be better placed to adapt to the new world that emerges in its wake.

“And most fundamentally, governance – the G in ESG – will be crucial to companies’ chances of coming through the crisis in good shape. There is a considerable opportunity for the most responsibly run companies to emerge from the crisis with improved operations and enhanced reputations.

“By identifying these companies, the managers of ESG strategies can offer investors the prospect of investing in a better and more sustainable future.”