Our “ESG 101” series aims to facilitate conversations between financial professionals and clients on environmental, social and governance (ESG) investing. Here, Kelly Hagg, Global Head of Product Strategy and ESG, and ESG Research and Development Analyst Quinn Massaroni delve into recent research that calls into question the pervasive idea that incorporating ESG means sacrificing returns.
Key takeaways
- Early approaches to ESG investing often relied on simply excluding companies or sectors based on ethical or values-based approaches.
- Over the past two decades, ESG integration has become more sophisticated, giving financial professionals more opportunities to find strategies that aim for both attractive ESG risk profiles and performance outcomes.
- Furthermore, recent research finds that integration of financially material ESG factors may offer increased risk protection and potential outperformance over the longer term.
You’ve likely seen the headlines about sustainable fund flows hitting record highs quarter after quarter. Or maybe you read about activist investor Engine No. 1 winning three ExxonMobil board seats in a push for climate strategy change. Or heard the news that electric vehicle startup Rivian’s listing on the Nasdaq last November was the largest initial public offering (IPO) of 2021 and the sixth largest in U.S. history.1
While the news cycle over the past several months makes it clear that ESG (environmental, social and governance) investing has a permanent place in our financial systems, we continue to see caution among financial professionals when it comes to adopting ESG in their practice.
In part one of this series, we discussed client demand for ESG and why financial professionals should care. Here, we tackle another topic that is inextricably linked to that question: the relationship between ESG investing and financial returns.
Skepticism of ESG investing is not new, but it has declined significantly. However, the once common idea that ESG investing always involves a trade-off between performance and favorable environmental and/or social outcomes is still a lingering concern for some investors and financial professionals. But this perception does not reflect the complexity of the relationship between ESG investing and performance, given the multiple fundamental and ESG-related factors that come into play. An ever-growing body of research indicates that a broad range of outcomes is possible for ESG investments, including notable examples showing that ESG considerations may potentially contribute to outperformance and help mitigate risk when factored in alongside other favorable investment conditions.1 This research also indicates that the benefits of applying an ESG lens are most often realized over the long term, which is particularly appealing to individuals who are looking to build sustainable wealth over their lifetimes.
When Doing Good Meant Sacrificing Returns
The early days of socially responsible investing were almost entirely defined by values-based or exclusionary investing, approaches in which specific sectors and sub-sectors are excluded from a portfolio based on ethical or moral judgments. Excluding companies or entire sectors inevitably reduced the size of the investable universe, which could lead to concentration risk and market underperformance.2 Depending on the extent and range of exclusions, performance may be impacted positively or negatively under certain market conditions. However, with exclusionary strategies leading the charge, socially responsible or exclusionary investing was largely considered a limiting exercise with the potential to hurt performance.
However, over the past two decades, the range of ESG applications in ESG-focused investing have become wider and investors now have access to more ESG investment options. For example, negative screening is now often paired with positive screening, while funds that employ best-in-class or active ownership strategies need not be sector limited; rather, they look at ESG criteria alongside other financial factors and incorporate them at the portfolio manager’s discretion.
With the focus on the purpose of ESG integration, financial professionals therefore have more opportunities to find more appropriate applications of ESG criteria, including strategies targeting ESG risk profiles and performance outcomes simultaneously. The task when considering these strategies is to take a closer look at how ESG factors are used in a particular fund and what the fund objectives are in relation to returns and sustainability outcomes.
Like conventional funds, the vast majority of funds that incorporate ESG considerations are focused on achieving competitive returns. Beyond satisfying the fund objective, the consideration of ESG factors can provide portfolio managers with additional perspectives to measure financially material risks, mitigate downside risk and build portfolio resilience. Financial professionals and individual investors can refer to a fund’s investment policy and philosophy to understand the investment objective and will typically find that investment performance is given top priority in ESG strategies, with impact investing being a common exception. As with all investment factors, ESG cannot guarantee investment returns, but these additional considerations are increasingly utilized to pursue market outperformance – as was the case for the MSCI ACWI ESG Leaders Index, which has outperformed the MSCI ACWI since 2007 on a cumulative and annualized basis (as of March 2021).3
ESG Integration to Maximize Risk-Adjusted Returns
In 2011, the Sustainable Accounting Standards Board (SASB, now the Value Reporting Foundation) introduced a materiality framework in which they set out to provide a standard guide to company disclosures on financially material sustainability (or ESG) information.4 Though SASB was not the only organization to consider the financial materiality perspective, their framework mainstreamed an important concept: different sectors are exposed to different ESG risks and, of those risks, some are more likely to have a financial impact on the companies’ performance.
Utilizing financial materiality frameworks help portfolio managers more effectively integrate ESG into investment strategies by narrowing the focus on financially material ESG risks and opportunities. The focus on financial materiality has also led to important research that helps validate the use of ESG factors in the pursuit of attractive risk-adjusted returns. For example, in 2016, Harvard academics and ESG experts studied firms’ future performance by rating and measuring their focus on financially material and immaterial ESG issues. Those firms with a strong grade on financially material issues and a weak grade on financially immaterial issues were found to have the best future performance, enhancing SASB’s argument that a focus on financial materiality has the potential to produce the best outcomes in ESG-integrated strategies.5,6
It is also important to remember that ESG integration is just one part of a broader investment strategy. To that end, research on financial performance and ESG has produced favorable but varied results indicating that the relationship between ESG and performance is driven by a number of different factors – both in how ESG is applied and in the overall investment process.
For example, a meta study of research from 1970 to 2014 showed that 63% of studies found a positive relationship between ESG and investment performance. The NYU Stern Center for Sustainable Business and Rockefeller Asset Management also conducted a meta study of over 1,000 research articles on ESG and performance from 2015 to 2020. In 59% of the studies, which focused on measures such as alpha and Sharpe ratio, ESG investments had better or similar performance when compared to conventional investments. However, we believe a more notable finding from the NYU Stern and Rockefeller analysis is that ESG integration strategies generally perform better than negative screening strategies.7
Using the UN Principles for Responsible Investment’s (PRI) definition of ESG integration as “the systematic and explicit inclusion of material ESG factors into investment analysis,” this finding indicates that it’s not simply a particular ESG label or blanket exclusions that can lead to attractive risk-adjusted returns; rather, it’s having a sound strategy for integrating ESG into the investment process that can potentially produce the best results.
We believe financial professionals can potentially benefit from considering these nuances to identify opportunities where ESG may contribute to outperformance. Equipped with this knowledge, they will likely be better prepared to engage clients in deeper conversations about ESG values and investment objectives – a topic we will be discussing in part three of this series.
Addressing Investment Risks with ESG
Beyond strictly focusing on return metrics, ESG investing can also be an important risk management and mitigation tool for long-term investors.
ESG investments have been found to be more resilient during market downturns that were driven by different types of global crises, including financial crises, the COVID-19 pandemic and the long-term crisis of climate change. Over the past two decades, a large body of research has shown that ESG investments have endured downturns better than their conventional counterparts, experiencing both lower drawdown risk and exhibiting higher resilience.2,8
There are different theories as to why companies with strong ESG credentials may be more resilient. Often it comes back to the fact that these companies tend to be better prepared to address material risks – from better governance to policies that help them address social and environmental challenges within their operations. The NYU Stern and Rockefeller meta study referenced earlier supports these findings with research that indicates ESG investments have historically offered a better way to manage risk, particularly during periods of economic or social crises. For example, the report pointed to the outperformance of German green mutual funds and FTSE4Good during the Global Financial Crisis of 2007-2009.7 Similarly, Morningstar released data showing how sustainable funds outperformed traditional funds following the start of the COVID pandemic.9
Climate risk assessments offer a vital perspective to help understand the financial impacts of a global crisis. The market has begun to respond to the devastating effects of climate change in earnest, from auto companies setting transition dates to electrify their fleets to states and countries committing resources to decarbonization programs. Those companies that understand and factor in different physical and transition risks related to climate change will be better able to manage and mitigate the longer-term risks associated with decarbonizing the global economy as net zero efforts accelerate.
Climate-Related Transition and Physical Risks
Moody’s Investors Service recently released data showing that G20 financial institutions have exposure to carbon-intensive sectors priced at $22 trillion.10 Given the macroeconomic impact of climate change and global commitments to decarbonize the economy, financial professionals or their clients may seek strategies that address a portfolio’s increasing carbon risk. Many ESG funds offer financial professionals options to address climate-related risks such as physical and transition risks. For example, these risks may include supply chain disruption or damage from physical climate events such as floods, fires or drought. Other climate risks may result from the transition to a low-carbon economy, where new regulations and technologies can increase company costs or render company assets obsolete (e.g., coal reserves lose value).
Beyond the global emergence of carbon-related regulations, technological advances are organically helping companies and consumers reduce their carbon footprint, whether in a company’s operations or a consumer’s buying behavior. In this sense, the transition to a low-carbon economy also presents a significant opportunity for financial professionals to identify emerging sectors that stand to benefit from the energy transition. With the increasing awareness of the social and economic costs of a carbon-based economy, climate-related ESG funds may be well positioned to better manage climate risks while benefiting from low-carbon opportunities.
Conclusion
Financial professionals who can integrate ESG analysis into their fund evaluation process may find that many investors are keen to benefit from the increased risk mitigation and potential outperformance ESG-focused investing can offer. Though their motivations may be different, investors near retirement could be interested in learning about additional ways to reduce volatility and downside risk, while younger investors may be more focused on the potential societal and environmental impacts of their investments.
Overall, ESG funds offer a wide range of opportunities to address different investor concerns and objectives. This creates a spectrum of ESG solutions that have the potential to intersect a complex variety of investor goals, time horizons and values. However, we believe that the focus on ESG and its impact on risk-adjusted returns depends on the style of ESG investing that is implemented. For example, an exclusionary approach or impact investing could potentially reduce or enhance performance under certain market conditions. In contrast, considering factors such as how prepared a company is for the transition to a low-carbon, circular economy – or how it treats its customers, workforce and suppliers – as part of wider investment analysis provides a holistic understanding of that company’s prospects. This understanding also allows asset managers and investment professionals to better understand a company’s risks and opportunities, which can lead to better outcomes over the longer term.
Financial professionals are uniquely positioned to understand the individual preferences of their clients and play an essential role in guiding them through the various options available. In this role, many financial professionals are already taking steps to better understand the relationship between ESG factors and portfolio risk and are increasingly using this insight to apply a financial materiality focused lens in their investment process. In our view, there is significant opportunity for financial professionals to use ESG not only to strengthen and customize the investment options they offer, but also to enhance client relationships by catering to investors’ diverse needs and objectives.
Environmental, Social and Governance (ESG) or sustainable investing considers factors beyond traditional financial analysis. This may limit available investments and cause performance and exposures to differ from, and potentially be more concentrated in certain areas than, the broader market.
Glossary
Alpha compares risk-adjusted performance relative to an index. Positive alpha means outperformance on a risk-adjusted basis.
The FTSE4Good Index Series is a collection of socially responsible, or ESG stock indexes administered by the Financial Times Stock Exchange-Russell Group (FTSE).
A green fund is a mutual fund or another investment vehicle that will only invest in companies that are deemed socially conscious or directly promote environmental responsibility.
MSCI ACWI ESG Leaders Index is a capitalization-weighted index that provides exposure to companies with high Environmental, Social and Governance (ESG) performance relative to their sector peers.
MSCI All Country World Index (ACWI) is a stock index designed to track broad global equity-market performance.
Sharpe ratio measures risk-adjusted performance using excess returns versus the "risk-free" rate and the volatility of those returns. A higher ratio means better return per unit of risk.
Volatility measures risk using the dispersion of returns for a given investment.
1“Amazon’s Huge Q4 Profit Has Nothing To Do With Its Core Online Retail Business.” Observer, February 4, 2022.
2Boffo, R., and R. Patalano. “ESG Investing: Practices, Progress and Challenges.” OECD Paris, 2020.
3“Responsible Investing, Sustainability and ESG: Debunking the Myths.” AXA Investment Managers. March 23, 2021.
4“An introduction to SASB Standards.” Sustainable Accounting Standards Board, 2022.
5M. Khan, G. Serafeim, A. Yoon. “Corporate Sustainability: First Evidence on Materiality." Harvard Business School Working Paper, No. 15-073, March 2015.
6“The ESG Advantage: Exploring Links to Corporate Financial Performance.” S&P Global, April 2019.
7“ESG and Financial Performance: Uncovering the Relationship by Aggregating Evidence from 1,000 Plus Studies Published between 2015-2020.” NYU Stern & Rockefeller Asset Management, February 10, 2021.
8“Debunking ESG Myths Part 1: The Fear of Sacrificing Financial Returns.” OpenInvest, April 14, 2021.
9“Sustainable Equity Funds Outperformance Traditional Peers in 2020.” Morningstar, January 8, 2021.
10“Data on G20 financial institutions reveals high exposure to carbon transition risk.” Moody’s Investors Service, September 23, 2021.
