ESG investors reap improved returns

Research from academics, asset managers and index providers has found a link between good ESG governance and improved financial performance, largely through risk reduction. Targeting high ESG performers can therefore pay real dividends to investors.

On the other hand, not implementing ESG can ‘cost’ companies and investors better returns and even mean losses, as anyone who had invested in Volkswagen before its diesel deception would have realised; VW shares have never recovered after it admitted to cheating emissions tests in the US in 2015.

Dr. Philipp Krueger, an Assistant Professor of Responsible Finance at the University of Geneva, has recently studied the relation between ESG characteristics and investment performance and says ESG reaps risk reduction for companies. Krueger says in a 2017 study he co-authored:

We provided evidence that investors with better sustainability footprints exhibit higher risk-adjusted investment performance. Our analysis suggests that the main mechanism through which better sustainability translates into better investment performance is not return enhancement but rather risk reduction. As such, we find that many standard risk measures are significantly lower for institutions with better sustainability footprints. It thus seems that integrating ESG considerations into investment decisions can contribute to better performance through improved risk management.¹

In their 2015 research paper, Finding Alpha in ESG,²Credit Suisse finds that all five portfolios that it constructed based on ESG data added alpha over a seven-year time horizon. Credit Suisse examined the opportunity to capture alpha using data from each of the three ESG pillars and concludes:

”For the Environment pillar data we conclude that strong management of environmental issues ‘’pays’’ and weak management of environmental issues "costs" at the portfolio level. We found similar results using the Governance pillar data, i.e., strong governance "pays" and weak governance "costs" at the portfolio level. For Social pillar data, we find that companies which have overall the weakest management capabilities and highest exposure to social issues significantly underperform all other companies, i.e., poor social performance "costs" at the portfolio level.”

Credit Suisse found that integrating ESG factors can enhance portfolio performance through both lower exposure to negative risks related to ESG factors and higher exposure to related opportunities, which can lead to material cost advantages, improved efficiencies and/or new revenue sources.

ESG ratings are, in addition, a possible lead indicator of management quality in that companies which are better managers of ESG factors may also be better managers of shareholder capital, Credit Suisse said.

Link between ESG and profitability

A new white paper from leading global index provider MSCI, Foundations of ESG Investing, evaluates how ESG characteristics can enhance portfolio performance.

MSCI is a leading global ESG researcher, with a team of over 170 analysts worldwide assessing all of the stocks in its global universe on a 'AAA' to 'CCC' scale according to their exposure to industry specific ESG risks and their ability to manage those risks relative to their peers.

In Part 2 of the white paper, Integrating ESG into Benchmarks, MSCI finds that two of its key ESG indices: MSCI ESG Leaders Index and the MSCI ESG Universal Index; enhanced risk reduction and led to better risk-adjusted returns compared to their parent index the MSCI All Country World Index (ACWI).

MSCI found that there was a clear reduction in all relevant risk measures for both of its ESG index methodologies, including: total risk or volatility; expected shortfalls; and maximum drawdowns, compared to the MSCI ACWI.

Other research backs these findings. In its study, A Quantitative Perspective of how ESG can Enhance your Portfolio, JP Morgan says the evolution within ESG investing means it now offers investors a measurement system to manage reputational and operational risk that companies face, which may impact on their long-term profitability. JP Morgan concludes:

ESG can enhance your portfolio by reducing volatility, increasing Sharpe ratios and limiting drawdowns … Our research highlights that the key attributes of ESG Investing lie within portfolio construction. While the return profile may not be the selling point, not having ESG factors in your portfolio significantly increases volatility, lowers potential Sharpe ratios and leads to a higher probability of suffering larger drawdowns during times of market stress”³

Indices and ETFs make it easy

MSCI is the world’s largest provider of ESG indices across both equities and fixed income with over US$170 billion benchmarked to MSCI ESG indices⁴.

Swiss Re, one of the world’s largest reinsurers, shifted its entire investment portfolio worth around US$130 billion to MSCI’s ESG index family in 2017, choosing benchmarks that systematically integrate ESG criteria rather than traditional market benchmarks.

Guido Fürer, Group Chief Investment Officer at Swiss Re, explained his decision:

These benchmarks represent a suitable tool to achieve the desired investment behavior (sic) and set the right measurement both from a performance and ESG perspective… MSCI is a leader in providing ESG indices for institutional investors, helping them with their ESG integration needs.⁵

One of the world’s largest pension funds, The Government Pension Investment Fund for Japan (GPIF), also selected MSCI indices as benchmarks for their ESG investment strategy in 2017.⁶

In Australia, institutional investors have been at the forefront of sustainable or responsible investing. It is estimated that around $622 billion in assets under management (AUM) was invested through some form of responsible investment strategy in Australia as at 31 December 2016. This was up 9 per cent from $569 billion in 2015, representing around half of all assets professionally managed in Australia (44 per cent), according to the Responsible Investment Benchmark Report 2017 from the Responsible Investment Association Australasia (RIAA).⁷

According to the report, “the comparison of responsible investment funds against mainstream equivalent funds and their benchmark index indicates outperformance across the majority of time periods”.⁸

Investors committed to ESG and who want to align their investments to their ethics and values can therefore have confidence that their investment choices can improve their portfolio returns. On the other hand, ignoring ESG factors can cost investors real dollars, not just missed opportunities.

VanEck’s MSCI International Sustainable Equity ETF (ASX: ESGI) has recently been certified as an ‘Ethical’ investment product by the RIAA. Launched on ASX in March 2018, ESGI provides investors with access to a portfolio of around 174 true-to-label sustainable international companies in a single trade. The smart beta ETF tracks the MSCI World ex Australia ex Fossil Fuel Select SRI and Low Carbon Capped Index which screens companies based on fossil fuel ownership and revenues, socially responsible activities, environmental, social or governance (ESG) performance and carbon emissions. Further details about  index methodologies and revenue screens can be found on the ESGI fund page.

_{¹P1 R. Gibson&P. Krueger (2017). The Sustainability Footprint of Institutional Investors. Swiss Finance Institute Research Working Paper No. 17-05, available at http://goo.gl/qzhvSC”.}

_{²Credit Suisse 2015, ‘Finding Alpha in ESG’.}

_{³JP Morgan 2016, ‘A Quantitative Perspective of how ESG can Enhance your Portfolio’}

_{⁴https://www.msci.com/documents/10199/df843280-e7ac-4876-a769-a1a53140546a}

_{⁵http://www.swissre.com/media/news_releases/nr20170706_MSCI_ESG_investing.html}

_{⁶https://www.msci.com/documents/10199/60420eeb-5c4e-4293-b378-feab6a2bf77f}

_{⁷P6, Responsible Investment Benchmark Report 2017 Australia.}

_{⁸P8, Responsible Investment Benchmark Report 2017 Australia., from the Responsible Investment Association Australasia.}