How ESG enhances your performance – the evidence

Key takeaways:

• Environmental, social and governance (ESG) principles can benefit single-stock returns. Evidence shows that shares of better-quality companies can perform better than inferior peers.
• ESG can benefit portfolio risk and return. Evidence shows that integrating ESG into the investment process and investing in companies with better ESG scores can add to performance.
• ESG integration can lead to lower risk. Evidence shows that ESG analysis can help deliver a similar return while reducing investment risk.

There remains considerable debate around the risk/return implications of integrating ESG considerations into investment decisions. These concerns often center on the belief that investors must "give up" performance when integrating ESG. That’s why we looked at the results of studies spanning different time periods and regions (including emerging markets) to try and get some answers.

While this is not an exhaustive review, we have tried to include analyses that are rigorous and robust, with an emphasis on peer-reviewed academic research.

Part 1. Does investing according to ESG principles mean sacrificing returns?

ESG & corporate financial performance

We reviewed research papers published in the Journal of Sustainable Finance & Investment, in the Journal of Portfolio Management and by the NYU Stern Center for Sustainable Business (itself a meta-study that reviewed more than 1,000 research papers).

They arrived at the conclusion that higher-quality companies, defined as those with better ESG ratings or scores, perform better on a fundamental basis, i.e., in terms of corporate financial performance (CFP). This fundamental performance could relate to, for example, broad-based profitability, return on equity (ROE), return on assets (ROA) or dividend payments.

ESG & company stock returns

We looked at studies of companies listed in the US, UK, emerging markets and elsewhere. They showed that:

• ESG quality is associated with lower volatility — and therefore lower risk — and consequently higher risk-adjusted returns
• High-scoring ESG stocks tend to have lower volatility and betas (i.e., systematic risk) than lower-scoring ESG stocks
• Companies in both developed and emerging markets with higher ESG scores generally experience lower costs of capital when compared to those with poorer ESG scores
• ESG integration can aid investors in China, with high-scoring ESG portfolios outperforming low-scoring ESG portfolios in normal circumstances, and especially during market turbulence.

Portfolio research & implications

It’s tempting to focus on what ESG can add to portfolio performance. However, equally important is the impact of ESG on a portfolio’s risk exposure. We think in terms of risk-adjusted returns: if two portfolios deliver the same return, the one with lower volatility would have higher risk-adjusted returns (i.e., it returns more per unit of risk).

Once again, our review of the research suggests that:

• ESG integration can reduce portfolio risk across the full spectrum of markets and investment styles
• Incorporating ESG criteria into portfolio construction may help to limit market risk

What is ESG quality, significance of materiality

So far, we have equated good ESG scores with ESG quality. But our experience teaches us that it is risky to consider ESG scores as the definitive view of a company’s ESG quality.

Investors need to understand the "materiality" of issues — their business impact on a firm — and interpret the ways in which a company is addressing material risks and opportunities. Some issues will be more pronounced, and present greater risks and opportunities, for firms depending on where, and in which industry, they operate. Part of the challenge of ESG is determining what is material for a company. Focusing on "strong" performance by a company on a non-material issue can give a misleading view.

A 2015 Harvard study found that firms which perform well on the ESG issues most material for themselves can out-perform those that don’t. Meanwhile, firms with strong performance linked to immaterial sustainability topics, do not outperform those with poor performance on immaterial topics.

Part 2. Implications for active management

Macro, thematic-level ESG research

Look to understand major themes and trends in ESG, and understand how they might affect firms. Our views on ESG build on the ‘4Ps’:

• People (including demographics);
• Policy (including governance and engagement);
• Planet (including environment and climate change);
• Progress (including technology and infrastructure).

Specific topics may include: decarbonization; sustainable products changing consumer preferences; supply-chain management; and financial inclusion.

Firm-level ESG research

Understanding the ways in which management is addressing and managing ESG issues, and embedding this into the core research process to help build a view of the quality of a company.

Whatever research you may use, do your own due diligence and research to build as full a picture as possible. Behavior and practices can be better (or worse) than disclosures might suggest, and so, relying only on company disclosure when assessing ESG does not provide the whole picture.

Help companies improve and enhance their ESG through active engagement. If there is a link between ESG scores and performance, then improving ESG scores (either by influencing behavior or simply improving disclosure) may help stock, and hence, portfolio performance.

We believe that companies that are well-managed, and which consider long-term risks and opportunities around ESG issues, should outperform over the long term

And finally…

ESG can have a very positive effect on both corporate financial performance and on portfolios. We believe that companies that are well-managed and consider long-term risks and opportunities around ESG issues have the potential to outperform over the long term.

There is evidence across many time periods and regions (especially in emerging markets) that integrating ESG into the investment process, and investing in companies with better ESG scores, can add to performance.