ESG investors reap improved returns

Sustainable or responsible investing is becoming increasingly popular as the community becomes less tolerant for companies acting unethically or that negatively impact the environment. The evidence is mounting too that incorporating environmental, social and governance (ESG) into a portfolio can improve investment returns and is fast becoming the norm.

According to the Responsible Investment Benchmark Report 2018 from the Responsible Investment Association Australasia (RIAA),¹$866 billion of assets under management (AUM), or 55.5% of all assets professionally managed in Australia in 2017 were responsibly managed. Asset managers incorporating ESG considerations into their risk management accounted for the vast majority of the total AUM.

RIAA found that core responsible investment (RI) Australian share funds outperformed the average large cap Australian share funds over three, five and ten year time horizons.²

Outside of Australia, research from academics, asset managers and index providers has found a link between good ESG governance and improved financial performance, largely through risk reduction.

On the other hand, not implementing ESG can ‘cost’ companies and erode returns, as the example of Volkswagen highlights; VW shares have never recovered after it admitted to cheating emissions tests in the US in 2015.

Outside of Australia, research from academics, asset managers and index providers has found a link between good ESG governance and improved financial performance, largely through risk reduction.³

UBS Global Chief Investment Officer GWM Mark Haefele recently said: “over 2,200 academic studies undertaken in the last 40 years have examined the relationship between ESG factors and corporate financial performance. More than 90% of them have found that ESG factors have a positive or neutral impact on financial returns.”⁴

Amundi, Europe’s largest asset manager and one of the top 10 worldwide, recently analysed the performance of 1,700 companies across five MSCI investment index groups using ESG criteria from 2010 to 2017. Amundi found that responsible investing could be a source of outperformance.

• From 2014-2017, responsible investing was generally a source of outperformance in the Eurozone and North America. In the Eurozone, all pillars (Environmental, Social and Governance) and ESG score integration displayed positive returns, with the Governance pillar dominating. In North America, ESG investing during the 2014-2017 period also displayed positive returns, although the Environmental component is the largest winner.⁵

Risk reduction a key benefit of ESG

Dr. Philipp Krueger, an Assistant Professor of Responsible Finance at the University of Geneva, has studied the relationship 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.⁶

In their 2015 research paper, Finding Alpha in ESG,⁷Credit Suisse found that integrating ESG factors can enhance portfolio performance both through 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 white paper from leading global index provider MSCI, Foundations of ESG Investing, has evaluated how ESG characteristics can enhance portfolio performance.

In Part 2 of the white paper, Integrating ESG into Benchmarks, MSCI finds that two of its key ESG indices, the 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.

In a study by UBS, "Measure what matters – expanding the scope of intrinsic value to include ESG", the fund manager back tested companies with strong governance profiles as determined by its ESG database and its proprietary valuation framework against the MSCI ACWI benchmark (during the period from January 1, 2010 to December 31, 2015). UBS found:

• The results show that companies that scored high in our ESG methodology consistently outperformed the MSCI ACWI benchmark … this test would suggest ESG can help mitigate downside risk and that incorporating ESG does not compromise alpha.⁸

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 indices.⁹It has 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.

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.¹⁰

Recently and for a fourth year running, MSCI was voted ‘Best firm for Socially Responsible Investment Research’, ‘Best Firm for Corporate Governance Research’ and ‘Best firm for Sustainability Indices and Benchmarks’ in the Independent Research in Responsible Investment (IRRI) Survey.   The survey was completed by 954 analysts, portfolio managers and companies from 44 countries.

The good news for investors is that as sustainable investment has gained in popularity, so has the choice of investments on the ASX issued by different providers in the form of exchange traded funds (ETFs). Factors that are important to consider:

• who the issuer is;
• their ability to track the ETF’s underlying index;
• management costs,
• the bid-ask spread cost on ASX; and
• most importantly, how they are making decisions about ESG factors. Understand where the research is coming from including the depth and breadth of the research team, and how is it being applied.

While some fund managers maintain that they incorporate ESG factors into their investment analysis, investors need to ask whether their ESG analysis is in-depth or superficial. If they don’t have a big team crunching the numbers and examining all aspects of a company’s operations beyond fiscal reports, their ESG analysis is likely to produce limited insight.

In contrast, MSCI’s large team delivers the analysis necessary to construct a portfolio with companies that demonstrate both a higher MSCI ESG Rating and a positive ESG trend, while maintaining a broad and diversified investment universe.

_{¹P4, Responsible Investment Benchmark Report 2018 Australia.
²P5, Responsible Investment Benchmark Report 2018 Australia.
³R. 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”.
³Credit Suisse 2015, ‘Finding Alpha in ESG’.
⁴https://www.ubs.com/magazines/wma/insights/en/investing/2018/sustainable-investing-can-propel-long-term-returns.html
⁵http://research-center.amundi.com/index.php/research_center_en_uk/layout/set/popin/layout/set/popin/page/Article/2019/01/The-Alpha-and-Beta-of-ESG-investing?search=true
⁶1 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”.
⁷Credit Suisse 2015, ‘Finding Alpha in ESG’.
⁸UBS, Can ESG Really Boost Performance: https://www.ubs.com/global/en/ubs-society/2018/can-esg-really-boost-performance.html
⁹https://www.msci.com/documents/10199/df843280-e7ac-4876-a769-a1a53140546a
¹⁰http://www.swissre.com/media/news_releases/nr20170706_MSCI_ESG_investing.html}