Environmental, Social and Governance Factors and Portfolio Performance

For decades, institutional investors throughout North America and Europe have been advocating improvements to the environmental, social and governance (or “ESG”) characteristics of publicly traded companies, in the belief that doing so will improve the long-term performance of their portfolios. Many investors also incorporate ESG factors into their security selection processes. In fact, according to the Global Sustainable Investment Association, a network linking the professional associations for responsible investment in Europe, Canada, the United States, Asia, and Australasia, US$13.6 trillion is currently invested using some kind of ESG factor for portfolio construction, corporate engagement, or both. This represents 21.8% of assets under management in the regions studied, with the proportion being higher in Europe (where almost half of all invested assets are subject to ESG strategies) and lower in the United States (where only 11% are). So what effect is all this activity having on performance? Academic research has reached several conclusions on the subject.

• There is a consensus that, on average, ESG portfolios perform comparably to conventional ones. However, it is important to realize that this is the result you get if you lump together a huge variety of ESG strategies and products.
• When you look at the research in a more disaggregated way, there is evidence that managers who focus intensively on ESG often outperform their peers. For example, this was found for funds run by ESG specialist firms in the United States in 1997-2005, and by a study of Islamic funds run by specialists in Islamic countries.
• A large majority of studies also find that strong ESG performance by a company contributes to increased firm value in some way, whether that is measured by operational performance, stock valuation, or both.
• The practical impact of ESG varies with an investor’s time horizon. Operational performance may be strong for some time before it is recognized by the market, and operational weaknesses may take some time to impact security prices, which are also influenced by many other factors. For these reasons, the value of ESG factors is typically seen in the medium term, and not necessarily in quarterly results.
• ESG strategies do not necessarily impair diversification. Some people still think that ESG means screening out large percentages of certain industries, but this is usually not the case. Many investors use a “best in class” approach to ESG, ranking companies relative to each other but including all industries. Moreover, even when investors do require certain absolute ESG standards for all investments, research has shown that at least in developed economies, the market of available securities is deep enough for these screens to have little diversification impact. In addition, a number of studies have found that stocks with good ESG profiles are less volatile, even after accounting for market cap and other factors. This may decrease portfolio risk.
• When it comes to particular ESG metrics, a number of studies covering the period from the mid-90s to the early 2000s have connected stock price outperformance to factors including employee relations, energy efficiency, sexual orientation nondiscrimination, and corporate governance quality.
• Other recent studies suggest that many of these factors are increasingly being recognized by the market. As a result, some investors seeking active return are shifting their focus to anticipating changes in ESG performance. In addition, inefficiencies clearly remain in the way the market assesses management quality. This is demonstrated by the many corporate crises and scandals that we see having a large stock price impact, although they could have been foreseen through ESG analysis.
• Investors often use ESG metrics in an industry specific way: environmental issues will be more important to energy-intensive or highly polluting industries, and labor issues more critical for retailers or manufacturers. Companies with a higher consumer-facing profile will be more sensitive to headline and reputational risk. Some issues, however, particularly on the governance side, are largely the same across industries, because they are core questions of management quality.

For more information and for citations to the academic studies mentioned above, readers can consult Ten Things to Know about Responsible Investment and Performance, a report released in 2011 by GMI Ratings. The document is publicly available here. Another good resource is Sustainable Investing, a literature review produced by Deutsche Bank Climate Change Advisors in 2012, available here.