How Top ESG Funds Managed to Beat the Market in 2022

Meanwhile, funds using environmental, social, and governance, or ESG, criteria came under attack. Conservative politicians pilloried ESG as a front for a leftist “woke” agenda, turning it into a polarizing political issue. Proponents of ESG, such as
BlackRock
(ticker: BLK) CEO Larry Fink, have said its critics “are trying to demonize the issues.”

“In 2022, ESG stood out for becoming reviled by some and more deeply embraced by others,” says Kathryn McDonald, co-founder of RadiantESG Global Investors, an investment firm backed by
HSBC Asset Management.

Against this backdrop, fund managers with an ESG mandate endeavored to outperform the market. A handful of them did. Based on data from Morningstar Direct, the top 10 U.S. equity mutual funds in Barron’s annual ESG survey outperformed the
S&P 500
index, returning an average negative 13.8% against a loss of 18.1% for the index.

Barron’s took a different approach to the rankings this year. Along with large-cap funds, we added small- and mid-cap funds. And we included only funds with an explicit mandate to invest according to sustainable or ESG principles.

The 2022 list ranks actively managed funds with at least $250 million in assets and more than a year of performance. A total of 33 funds passed the test, holding more than $94 billion in combined assets. Funds were ranked by returns for the 12 months ended on Dec. 31.

In past years, Barron’s screened more expansively, including funds that scored an above-average sustainability rating from Morningstar. A high rating, based on underlying portfolio holdings, however, doesn’t mean that a fund invests with ESG screening criteria or takes an active approach to finding stocks with high sustainability scores. Our new methodology excluded funds that may have achieved a high score as a byproduct of other factors.

We made this change amid a growing controversy over what, exactly, ESG means and how to screen for it. The term is often conflated with sustainable investing, which some critics say is wrong because they aren’t the same thing. ESG is a data tool for risk assessment, evaluating the impact of corporate practices on the bottom line. Sustainability encompasses a company’s efforts to minimize its environmental impact on the planet.

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The industry has come in for criticism because the ESG acronym itself is like a Rorschach test—a mirror of investors’ aspirations or a front for something else, displaying what one wants to see or considers important.

Other strategies are vague, too—value, after all, is in the eye of the beholder. But ESG indexes and related ratings now affect an estimated $8.4 trillion in U.S. assets. ESG scores are used extensively in corporate and fund marketing. And disagreements over its substance and goals are glaring. Many ratings, for instance, don’t evaluate a company’s total impact on the environment, how it treats workers, or whether it abides by shareholder-friendly corporate governance.

Rather, ESG ratings often place a heavy emphasis on the impact of climate change on the corporate bottom line. A business could score well if climate change isn’t perceived as a risk to profits, or it may achieve high marks if it’s trying to mitigate the impact. An oil producer could win a high score if it’s investing in renewable energy. Tech companies also tend to rate highly because of their low carbon footprint, even if tons of computer waste ends up in landfills, or components come from copper and lithium mines with near slave-labor practices.

The ambiguities make for inconsistencies and harsh criticism. Last year, for instance,
Tesla
(TSLA), the global pioneer of electric vehicles, was booted from the S&P 500 ESG Index. S&P said it made the change because Tesla lacked a comprehensive low-carbon strategy and faced allegations of racial discrimination and poor working conditions at a factory in California. S&P kept
Exxon Mobil
(XOM) in its ESG index, however, prompting an angry response from Tesla CEO Elon Musk. “ESG is a scam,” he said on Twitter. “It has been weaponized by phony social justice warriors.”

The Securities and Exchange Commission last year proposed disclosure and naming rules for ESG funds in an effort to address “greenwashing,” a practice whereby companies or funds exaggerate environmental claims. “It is easy to tell if milk is fat free,” said SEC Chairman Gary Gensler last March. “It might be time to make it easier to tell whether a fund is really what they say they are.”

Burton Malkiel, an economist and author of the book A Random Walk Down Wall Street, also takes issue with ESG. “There’s very little agreement on what’s a good or bad company,” he says. “It’s nothing like bond ratings where S&P and Moody’s are correlated 99% on rating corporate bonds.” Malkiel adds that in his own research, he found that ESG funds didn’t beat the market long term.

Many ESG industry insiders welcome the scrutiny. “There’s no real barrier to labeling your products,” says Anuj Shah, a partner at Close Group Consulting, an ESG advisory firm. “There should be scrutiny.”

Corporate pressure campaigns also appear to be working in areas like carbon emissions and workforce diversity. Last January, 70% of
Costco Wholesale
(COST) shareholders backed a proxy proposal for the retailer to set out plans to reach net-zero greenhouse-gas emissions by 2050 or sooner. In November, Costco committed to set new climate targets in 2023.

Inside the 2022 Winner’s Circle

How did last year’s top performers fare? One theme that worked was emphasizing value over growth. Many ESG funds hold large slugs of high-growth tech stocks, partly because the industry is perceived not to have a large impact on carbon emissions. But tech was a disaster last year, tumbling 33%; funds that were underweight the sector had a tailwind. Funds that emphasized value got another boost, as large-cap value stocks fell just 7.5%, on average, including dividends.

The top-ranked fund,
DFA U.S. Sustainability Targeted Value Portfolio
(DAABX), delivered a return of negative 8.3%, less than half the S&P 500’s loss. The fund holds more than 1,100 small- and mid-cap stocks, selected according to Dimensional Fund Advisors’ quantitative models, which target the same factors as other DFA portfolios: value, smaller-size, and profitability. This fund also excludes companies with high carbon emissions or large fossil-fuel reserves.

“It’s very systematic,” says Jim Whittington, head of responsible investment at Dimensional. “It’s really looking at emissions intensity.” The fund also excludes companies associated with coal, palm oil (due to deforestation), child labor, and factory farming, among other areas. Stocks that helped lift returns include
First Solar
(FSLR),
Universal Health Services
(UHS), and
Reliance Steel & Aluminum
(RS).

DFA also notched the ninth-best performer last year:
DFA US Sustainability Core 1 Portfolio
(DFSIX). The fund holds nearly 2,000 stocks but tilts toward deeper-value small companies with high profitability. The strategy homes in on companies that are more sustainable than peers, based mainly on screens of carbon emissions. DFA also avoids sectors such as coal and tobacco, and companies involved in deforestation.

Dimensional funds are known for low portfolio turnover and low expense ratios, features that can improve returns. The mutual funds are available only through financial advisors, though Dimensional has launched sustainable exchange-traded funds that track similar portfolios, including
US Sustainability Core 1
(DFSU).

Asset manager Boston Trust Walden fared exceptionally well, with three funds in the top five, led by Boston Trust Walden Small Cap (BOSOX).

Co-manager Richard Williams looks for high-quality small-caps trading at reasonable valuations. In energy, he prefers oil-and-gas services stocks for their relative stability. One holding,
Cactus
(WHD), makes wellhead and pressure-control equipment. The stock gained 31.8% in 2022. Another holding, contract driller
Helmerich & Payne
(HP), rose 109.2%.

Other stocks that fueled gains for the fund include biotech clinical-trial firm
Medpace Holdings
(MEDP), bakery company
Flowers Foods
(FLO), and data analytics firm
ExlService Holdings
(EXLS). All helped the fund beat 93% of peers in the small-cap blend category.

Williams doesn’t necessarily look for the highest ESG scores, though ESG data is integrated into his stock-picking. “At a high level, sustainability to us means more than just a good ESG profile in Sustainalytics or something else,” he says. “It’s a broader concept.” The portfolio does exclude some sectors with poor ESG scores, including alcohol, tobacco, private-prison operators, and factory farming.

Boston Trust SMID Cap
(BTSMX), also co-managed by Williams, landed in fourth place. The fund focuses more on mid-caps and integrates ESG factors into stock selection, though it doesn’t have a hard rule against any industries. Helmerich & Payne and
J.M. Smucker
(SJM) helped performance, along with
Lamb Weston Holdings
(LW), a frozen-potato company whose stock rose 41%.

At
Boston Trust Walden Equity
(WSEFX), ranked fifth, co-manager Mark Zagata says that ESG analysis is integral to stock-picking and applies it across three core criteria: quality, sustainable businesses, and reasonable valuation.

“ESG is a significant part of the sustainability aspect because so much of a stock’s value is tied into the long run,” he says. Among the fund’s winners in 2022 were
Deere
(DE), up 25%, and oil-and-gas producer
ConocoPhillips
(COP), up 63.5%.

More strict in its screening practices is
Transamerica Sustainable Equity Income
(TADFX), which ranked third. The fund abides by standard ESG screens—excluding areas like gambling, tobacco, weapons, nuclear power, fossil fuels, and animal testing. Every stock must also pass muster with Miranda Beacham, head of ESG at Aegon Asset Management, the fund’s subadvisor. The team ranks companies as ESG leaders, improvers, and laggards, the last being a deal breaker for the fund.

Co-manager Mark Peden favors reasonably priced companies that have wide economic moats, good track records, and solid management. He also pays attention to dividend yields, since stable income is a fund mandate.

Two stocks that helped performance in 2022 were steel maker
Steel Dynamics
(STLD) and electric-power company
AES
(AES). Both fall in the “improver” camp. Steel Dynamics has set a goal to be carbon neutral by 2050. AES said in 2022 that the company intends to quit using coal by 2025. Beacham says conversations with both companies reassured her team that they had credible plans to achieve their targets. Amid strong demand for commodities and energy, both stocks fared well, gaining 57.4% and 18.4% last year, respectively.

Two of the biggest names in ESG—Parnassus Investments and Calvert Research & Management—also made their way into the winner’s circle.

Parnassus Value Equity
(PARWX) pulled ahead, in part, by adding to healthcare stocks and cutting back on tech. Portfolio manager Billy Hwan integrates ESG analysis into fundamental stock-picking, he says, looking for cheap companies that are also good ESG citizens. In tech, for example, data privacy and security are “top of mind.” The fund also excludes controversial businesses such as fossil fuels and for-profit prisons.

Two stocks that helped performance were
Merck
(MRK), up 44.8%, and
Vertex Pharmaceuticals
(VRTX), which climbed 31.5%.

The fund stands out for its long-term record: it ranks first on Barron’s ESG list for three-year returns with a 12.9% annualized gain. It also outperformed 99% of its large-cap value peers over that time, according to Morningstar.

Calvert Small-Cap (CCVAX), another top-10 fund, stuck to its knitting through a tough market. “We buy great companies, don’t overpay, and have a long-term perspective,” says co-manager Griff Noble. Stocks must adhere to Calvert’s ESG principles, which favor companies that promote environmental sustainability, “equitable societies, and accountable governance.”

Two standout stocks from 2022 were
Performance Food Group
(PFGC), up 27.2%, and natural-gas company Archaea Energy, which
BP
(BP) acquired in December.

Calvert Equity
(CSIEX) stood out for another reason: It was one of the few growth funds to outperform. The fund’s benchmark is the
Russell 1000 Growth
index, which fell 29.8%. The fund beat it with a negative 17.6% return. Manager Joe Hudepohl looks for quality sustainable businesses with long-term growth drivers—elements, he says, that offer “the highest return with the least amount of risk.” Over the past three and five years, the fund outperformed 93% and 98% of its large-cap growth peers.

One of the fund’s biggest holdings is card network
Visa
(V), which fell just 4.1% in 2022. “If you look at some of the things that they do relative to peers—strong diversity, governance, and environmental performance—they tend to outperform,” he says.

Both Calvert’s small-cap and large-cap funds also beat their benchmarks over the past five years. That’s a sign that ESG and sustainability screening, at least for some funds, doesn’t have to be synonymous with below-average returns.

Write to Lauren Foster at lauren.foster@barrons.com