There is now convincing evidence that ESG factors can – and do – affect investment risks and returns across a range of asset classes. There is a large body of research and empirical evidence that illustrates this to be the case.
Importantly, ESG factors are likely to become more material to investment performance over a medium to long-term time horizon due to increased uncertainties around how sustainability issues like climate change will affect society and economies.
Studies indicate the following about the link between ESG and investment performance:
- On average and in the aggregate, ESG portfolios perform better or equal to conventional ones over time
- Analysis of ESG factors sometimes flags unpriced risks and opportunities that are soon to be recogniszed by the market.
- In other cases, the ESG risks and advantages identified through RI analysis are either already priced by the market or will only affect stock prices in the long term.
- Some RI strategies can reduce volatility.
- ESG risk-optimized strategic asset allocation can improve expected portfolio performance at similar levels of expected portfolio risk, or reduce expected portfolio risk at the same levels of expected return.
- The notion that Responsible Investing may have a negative impact on diversification is often a misconception based on the use of negative screening alone. However prominent research by Credit Suisse shows that negative screening can still be a viable option over the long-term if optimisation methods are used. to adequately and also if performance is measured over the long-term.
- However recent discussions around the systemic short-comings of Modern Portfolio Theory and its effects on the investment industry, adds the important point that a fixation on performance is irrelevant because of an inherent bias towards short-term relative returns, rather than longer-term absolute returns as well as not focusing at all on mitigating systemic risks. As a result, the investment industry spends much of its effort competing with itself, not serving its customers’ needs which may be articulated as providing a reasonable, risk-adjusted return to people saving to offset long-term liabilities, through efficiently allocating capital to improve the economy and society.
- The suggestion is that asset owners and asset managers should in addition to looking at ESG and its impact on performance, also focus efforts on how they can contribute to an improved absolute market return, and thereby ultimately derive investment value over the long-term, though engagement around issues of systemic risk and effective stewardship. See further in the deep dive on RI and Investment Performance below.
See further in the deep dive on RI and Investment Performance below.
Deep Dive: RI and Investment Performance
Around the world, many investors have now been running RI portfolios in the Listed Equity space for several years. This provides a wealth of historical information on the performance track record of those portfolios. Performance can be compared to “non-RI” benchmarks, such as indexes like the FTSE/JSE Top 40, the FTSE 100 or the MSCI Emerging Markets Index. The results can also be analysed to see if out-performance (or under-performance) can be attributed to the RI part of the investment methodology and to ESG issues.
Similarly, specialised RI indexes like FTSE4Good, the FTSE/JSE Responsible Investment Index Series (previously in 2004-2015 called the JSE SRI Index) and the Dow Jones Sustainability Index have also now been running for several years, allowing their performance to be compared with “non-RI” benchmarks.
In addition, there is now enough case study information for analysts and academics to begin studying how the market has punished (or rewarded) companies as a result of ESG factors. Changes in share price can be correlated with issues such as the announcement of BEE deals, or to “shocks” resulting from problems and scandals.
The results from such academic research and analysis must be scrutinised expertly and carefully. Studies may differ in terms of both methodology and quality. The RI portfolios that studies look at can also be very different. Not all RI portfolios are set up with the same core investment objectives (e.g. value/growth, small cap/large cap), RI index construction methodologies can be very different and not all responsible investors use the same ESG information or apply this to their analytical approach and stock picking in the same way. Some asset managers simply have better investment teams and ESG analysts than others. They may also have performance-related reward systems for investment staff that are better aligned with the long-term time horizon that is inherent in the concept of RI.
Conclusions drawn from the past performance on one RI portfolio or one specific study cannot be applied automatically to everything else that falls under the RI umbrella. In addition, the standard caveat applies: past performance is not a guide to future performance. However, several studies, meta-analyses and literature reviews have now been done to look at this type of evidence as a whole.
A critical part of the rationale for RI is that the future is not going to be like the past, because sustainability issues are becoming more important.
For example, if policy makers and society are not able to mitigate climate change effectively, impacts such as sea level rise and changes to agricultural productivity will be costly. Adaptation may be possible to a certain extent, but will require investment. Insurance markets may be able absorb some risk, but not all. Other consequences may simply be beyond anyone’s control. On the other hand, if policy makers and society are able to make a global transition to a low carbon economy, this will also involve costs, investment and structural change.
Climate change is an obvious and dramatic example, but well-informed assumptions of a similar kind can be made about other pressures such as poverty, inequality, population growth, health and nutrition, water scarcity, fossil fuel depletion, biodiversity loss, and a host of other key development issues. Inaction in the face of these growing problems and preventable surprises will hit the economy. Action will also involve costs and change. On the other hand, tackling these issues through transition to a “green economy” also creates some significant investment opportunities.
For example. IFC estimates the climate business investment potential in South Africa to be in the region of $588bn in selected sectors over the next 10 years alone.
Many investment banks, quantitative analysts, academics and others in the field, including IFC and other multilateral financial institutions, are now focusing on the impact that these issues may have on long term investors, and are developing ESG analysis tools, RI strategies and portfolios that aim to predict and address the investment risks involved. Most of this work to date has focused on climate change and carbon. For example, the FSB’s Climate Disclosure Task Force. Similarly, several service providers have developed RI investment products based on optimising the portfolio for carbon risk, taking into account different scenarios for the price of carbon.
There is now a growing body of rigorous and authoritative research on the ways that RI techniques and ESG analysis can protect investor value and reduce risk, taking into account future development scenarios.
Research indicates that ESG analytics will become more important for protecting value and enhancing returns in the future.
Recent discussions around the systemic short-comings of Modern Portfolio Theory, adds the important point that a fixation on whether an ESG fund or index has outperformed or underperformed is irrelevant because of an inherent bias in the investment industry towards relative performance in the short-term, in addition to the belief that investors behaviour don’t impact market risks.
Early initiatives such as the Marathon Club suggested that asset owners should rather focus efforts on their own contribution to the creation of systemic market risks and how they can enable an improved absolute market performance, and thereby ultimately derive investment value over the long-term.
Pension funds that took bold steps in the early days of Responsible Investing in relation to a focus on absolute real-world and systemic impact (as opposed to a fixation on short-term outperformance of a given benchmark which in itself may not measure overall market improvement or societal progress) include CalSTRS, CalPERS and the Norwegian Pension Fund.
- Credit Suisse Investment Yearbook 2020:
- 2018 Pension Insurance Corporation plc. The Purpose of Asset Management: https://www.pensioncorporation.com/media/136165/purpose-of-asset-management-report-final-low-res.pdf
- Oxford / Arabesque’s study “From Stockholder to Stakeholder” (March 2015) https://arabesque.com/research/From_the_stockholder_to_the_stakeholder_web.pdf
- PRI “HOW ESG ENGAGEMENT CREATES VALUE FOR INVESTORS AND COMPANIES”https://www.unpri.org/download?ac=4637
- Robert G. Eccles, Ioannis Ioannou, and George Serafeim, The Impact of Corporate Sustainability on Organizational Processes and Performance. https://www.hbs.edu/faculty/Publication%20Files/SSRN-id1964011_6791edac-7daa-4603-a220-4a0c6c7a3f7a.pdf
- Mozaffar Khan, George Serafeim, and Aaron Yoon, “Corporate Sustainability: First Evidence on Materiality” – http://www.sustainablefinance.ch/upload/cms/user/CorporateSustainability_Firstevidenceonmateriality_Khan_Serafeim_Yoon_February2015.pdf
- Deutsche Bank (2012) Sustainable Investing: Establishing Long-Term Value and Performance, https://www.db.com/cr/en/docs/Sustainable_Investing_2012.pdf
- Gunnar Friede, Timo Busch & Alexander Bassen (2015) ESG and financial performance: aggregated evidence from more than 2000 empirical studies, Journal of Sustainable Finance & Investment, http://www.tandfonline.com/doi/pdf/10.1080/20430795.2015.1118917