"There is a narrative that ESG investing comes at a price – lagging performance relative to an unconstrained portfolio. The data does not support that contention, and in fact shows that these strategies often outperform the overall market. Many advisors have a naïve assumption that all Sustainable investing strategies screen and weight securities the same way. Of course, this flawed assumption couldn’t be further from the truth."
- Tony Davidow, CIMA® President and Founder of T.Davidow Consulting, LLC
Understanding the Approaches
In the 1990’s Socially Responsible Investing (SRI) became a convenient way of expressing your views about unpopular activities. For investors opposing Apartheid practices, investors could choose to exclude companies doing business in South Africa. They could express their displeasure with tobacco, alcohol and gaming by excluding ‘sin stocks’ and/or eliminating companies that damaged the environment. Excluding these companies often came at a price – and many investors shied away from adopting an SRI approach.
In the last couple of years, Environmental, Social & Governance (ESG) screening became popular with large institutions and HNW families. ESG is a relative screening methodology that provides the highest weights to companies that exhibit the best practices (see below). Multiple studies have shown that these strategies have historical outperformed their comparable index.
According to first-quarter 2020 Morningstar data1, “The returns of 70% of sustainable equity funds ranked in the top halves of their categories and 44% ranked in their category's best quartile.” In addition, 24 out of 26 sustainable index funds outperformed their conventional counterparts. These results shouldn’t be surprising. Good companies with sound policies and engaged employees should do better over time.
Analyzing the Results
There are some intuitive conclusions that we can draw from the short-term results. Oil has been plummeting, and people aren’t driving and flying like they used to – but there’s much more to this story. ESG screening is designed to identify companies with strict environmental policies, engaged employees and strong corporate governance (checks-and-balances).
MSCI research has shown that ESG screening effects valuations, risks and performance of underlying indexes2. Strong ESG companies typically exhibit above-average risk controls and compliance standards. Because of the better risk control standards, companies are less prone to severe incidences such as fraud, embezzlement, and litigation among other issues. Lastly, less-frequent and less-severe risks, leads to less stock-specific tail risks.
MSCI research also showed that companies with a strong ESG profile are more competitive than their peers, with a more efficient use of capital, better human capital development and better innovation. Strong ESG companies use their competitive advantage to generate better returns which leads to higher profitability, and higher profitability results in higher dividends.
Companies with strong ESG profile are less vulnerable to systematic market shocks and therefore show lower systematic risk. For example, these companies are often less vulnerable to spikes in commodity prices. Lower systematic risk generally means that a company has lower beta and therefore investors require a lower rate of return. This translates into a lower cost of capital. Finally, a lower cost of capital leads to a higher valuation.
Analyzing the characteristics of strong ESG profile companies provides great insights. These companies often have better risk control measures and consequentially exhibit lower tail risk. These companies generally exhibit higher profitability and higher dividends. Because of their low systematic risk, they typically have a lower cost of capital and higher valuation, which should lead to strong sustainable growth.
Selecting the Right Strategy
Based on advisor and investor interest, there has been a plethora of new sustainable investing products coming to the market over the past couple of years (mutual funds, ETFs and SMAs). Investors need guidance in selecting the right solutions. There are a number of key considerations:
- Do you gain exposure via an active or passive strategy?
- What has been the experience of the Portfolio Management team?
- How long have they been managing ESG / Sustainable portfolios?
- How do they screen and weight securities?
- What has been the historical track record?
"In a world where advisers are under pressure to demonstrate their value to investors, ESG represents an opportunity to distinguish their value proposition. Investors need education regarding what these strategies are, how they work and how to measure their impact? Advisors should embrace ESG as way of aligning an investors purpose and portfolio."
1 Hale, John, “Sustainable Funds Weather the First Quarter Better Than Conventional Funds”, April 3, 2020
2 Giese, Lee, Melas, Nagy & Nishakawa, “Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk and Performance”, The Journal of Portfolio Management, July 2019