1. The aggregate view - a positive effect
- The most comprehensive examination of the relationship between ESG and corporate financial performance supports the idea that employing ESG criteria in investment decisions improves financial performance.(1)
- This landmark meta-study evaluated the results of over 2000 individual analyses of ESG performance across asset classes and regions between 1970 and 2014. It found that nearly half showed a positive relationship between ESG and corporate financial performance with only 11% finding a negative relationship.
- The report’s authors conclude: “We clearly find evidence for the business case for ESG investing.” However, readers should note that firm-level studies were significantly more likely to find a positive relationship than portfolio-level studies, something the authors attribute to the greater costs and noise present in portfolio studies.
Per cent of studies that find a positive, neutral, mixed or negative relationship between ESG and corporate financial performance. Source: Friede, Busch & Bassen (2015), Journal of Sustainable Finance & Investment; Fidelity International, March 2018.
2. Positive filtering - granularity matters
- A recent study into ESG performance analysed the returns of 157 ‘best in class’ companies over two years between 2014 and 2016 and found that positive ESG filtering improved returns and reduced volatility overall, but that there was considerable variation between industries.(2)
- Particularly striking were the results in the energy and food & beverage industries: stocks with high ESG ratings showed significant outperformance compared to their respective reference portfolios over the sample period.
- In addition, not only were returns for high-ESG portfolios greater in eight of the study’s twelve industries, the ESG portfolios also displayed lower volatility across the board when compared to industry peers. While the results varied across industries, a key takeaway is that stocks with lower ESG ratings come with additional risk that is generally not rewarded by higher returns.
Study compared returns of members of the Dow Jones Sustainability Index to 809 randomly chosen equities between 2014-2016. Source: Kumar et al (2016), Journal of Sustainable Finance & Investment; Fidelity International, March 2018.
3. Negative filtering - implementation is key
- Excluding companies based on the products they produce is often considered a drag on portfolio returns - the avoidance of these ‘sin’ stocks by ethical investors causes them to be cheap relative to the market, improving their expected return.
- Conversely, excluding companies based on poor conduct (governance, workers’ rights, environmental issues, diversity etc) is typically considered a long-term-alpha-positive strategy because these are factors which tend to enhance corporate performance when done well, in addition to lowering the idiosyncratic risk of a significant negative event such as a corporate scandal.
- This view is broadly supported by a March 2018 report from Norway’s sovereign wealth fund detailing the cost of exclusions from its portfolio, as shown in the chart below. (The fund recently passed $1 trillion in assets and owns around 1.4% of all equity globally).(3)
- Interestingly, research shows that the avoidance of sin stocks (tobacco, weapons, alcohol, gambling) in European countries varies according to the prevalent religion of the country in question. Protestant countries appear more ‘sin averse’ as sin stock valuations are generally lower than comparable firms listed in Catholic countries.(4)
Effect of ESG exclusions on returns, 2006-2017, annualised. Source: NBIM, Fidelity International, March 2018.
4. There’s no such thing as an average asset
- It is tempting to focus solely on average performance but averages can be misleading, especially when considering real assets.
- Recent research shows that following ESG principles in infrastructure and real estate not only affects the mean return of funds, but also a significantly alters the variance of returns compared to non-ESG funds.
- Coupled with the long investment horizons of infrastructure and real estate, investors need to make sure they have a firm handle on their risk budget when implementing ESG and, as ever, conduct appropriate due diligence when selecting funds.
Pooled IRR of infrastructure and real estate funds with vintage years between 1997-2014. Column represents the spread between the 95th percentile and the 5th percentile, line shows the median. ‘Impact’ funds selected for their intent to generate social and/or environmental returns alongside financial returns. Source: Cambridge Associates and Global Impact Investing Network, 2017, Fidelity International, March 2018.
5. Not only what and how, but also where
- Friede, Busch & Bassen’s meta-study also reveals how location can influence the relationship between ESG and financial performance.
- The standout reading in the data is the difference between emerging and developed markets: a significantly greater number of studies find a positive relationship between ESG and corporate financial performance in emerging markets than in developed markets. This is probably due to lower ESG standards across the board in these markets resulting in larger potential gains relative to peers for companies that adopt ESG measures.
- Also interesting is the lower number of studies that find a positive ESG-performance relationship in developed Asia Pacific economies. This could be due to the high number of family-controlled businesses in Asia that score poorly on global governance standards but are not punished by inferior performance for historic/societal reasons.
Per cent of studies that find a positive and negative relationship between ESG and corporate financial performance. Studies conducted 1970-2014. Source: Friede, Busch & Bassen (2015), Journal of Sustainable Finance & Investment; Fidelity International, March 2018.
6. Active or passive?
- In recent years, representative US equity ESG indices (based on positive filters) have not deviated much from either the S&P 500 or the Russell 3000. In fact, there is no statistical difference between the return series of the ESG indices shown in the chart below and either the S&P 500 or the Russell 3000 (whichever is the most appropriate benchmark).
- This would indicate that investors with long time horizons can switch to an ESG equity index from a traditional passive index and still expect to achieve market returns. However, this can come with subtle changes in exposure (ESG scores are positively related to market cap and negatively related to market beta, for example(5)) that will cause results to vary across different stages of the economic cycle.
- In addition, the definition of ESG is constantly evolving - what was deemed a responsible investment 20 years ago would not pass scrutiny today. Passive indices by their very nature have fixed rules that may not be appropriate further down the investment time horizon and may fail to capture the more nuanced aspects of ESG metrics.
- The similarity of these ESG indices to their benchmarks also implies that active stock pickers are not necessarily disadvantaged by selecting from a pool that does not include those companies that score poorly on ESG metrics.
- As interest in ESG continues to grow, reputational damage to companies that breach socially acceptable standards will only increase, meaning there will be an increasingly negative skew to firm-specific ESG risks that passive portfolios may not be able to avoid.
Source: Thompson Reuters, S&P Dow Jones indices, Fidelity International, March 2018.
Source: Thompson Reuters, Fidelity International, March 2018.
7. Rating the ratings
- Lastly, if the above charts didn’t give you enough to think about, consider this - the performance of your investments will be materially affected by who provides your ESG ratings.
- The chart below shows the difference in annual returns between a portfolio of bonds with a high ESG rating and a portfolio of bonds with a low ESG rating, with ratings provided by Sustainalytics and MSCI.
- The headline takeaway appears to be that high ESG ratings improve bond returns, especially governance metrics, but just as interesting is the margin of difference in performance between the two ratings providers.
Annualised difference in returns of high ESG over low ESG bond portfolio 2009-2016. Source: MSCI, Sustainalytics, Barclays Research, Fidelity International, March 2018.
- Aggregating the research in this area shows a positive relationship between ESG investing and financial performance, although the effect appears to be significantly stronger at the firm level than the portfolio level - possibly the cause of the lack of industry consensus on this subject.
- However, results vary considerably based on implementation, asset class, region and ratings provider to name but a few.
- It is important to weigh up financial and non-financial goals of ESG investing before deciding which flavour is correct for any specific needs - when it comes to ESG implementation, one size does not fit all.
(1) Friede, Busch, & Bassen. (2015). ESG and financial performance: aggregated evidence from more than 2000 empirical studies. Journal of Sustainable Finance & Investment.
(2) N. C. Ashwin Kumar, Camille Smith, Leïla Badis, Nan Wang, Paz Ambrosy & Rodrigo Tavares (2016): ESG factors and risk-adjusted performance: a new quantitative model, Journal of Sustainable Finance & Investment.
(4) Julie Salaber (2013): Religion and returns in Europe, European Journal of Political Economy.
(5) NN Investment Partners, (2017): The materiality of ESG factors for equity investment decisions: academic evidence.
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