What makes ESG investing better?

Companies with high ESG scores exhibit some important characteristics that help explain their better risk-adjusted performance. 

By Anthony B. Davidow

(About the author: Tony Davidow is president and founder of T. Davidow Consulting, an independent advisory firm focused on the challenges facing the financial services industry. His focus is on helping advisers and investors incorporate complex strategies in their portfolios.)

WILTON, CONN. (Callaway Climate Insights) — Critics will argue that ESG investing lags the market, but the data tell a different story. Does ESG investing come at a price? Do these strategies underperform the market? 

According to a Fortune article, “There's a growing body of evidence to suggest that stocks of companies that meet high standards for environmental, social and governance factors (ESG) are actually likely to outperform the market. In other words: Investors can do well by backing companies that do good. Data from asset management startup Arabesque, for example, found that S&P 500 companies that ranked in the top quintile for ESG factors outperformed those in the bottom quintile by more than 25 percentage points between the beginning of 2014 and the end of June 2018, while their stock prices were less volatile.”

The Morgan Stanley Institute for Sustainable Investing analyzed Morningstar data of over 10,000 funds from 2004-2018 and found that sustainable funds delivered results in line with comparable traditional funds while reducing downside risk. Their data showed that during periods of extreme volatility, sustainable funds were more stable than traditional funds, exhibiting a 20% smaller downside deviation than comparable unconstrained funds.

Morningstar first-quarter data showed: “The returns of 70% of sustainable equity funds ranked in the top halves of their categories and 44% ranked in their category's best quartile.” Of course, we are not drawing conclusions based on one time period, but we shouldn’t ignore this data either, especially given the extreme nature of the drawdown.    

What do the data tell us?

If we dig into the data a bit more, we begin to see a very compelling story. Companies with high ESG scores exhibit some important characteristics that help explain their better risk-adjusted performance.  

MSCI research shows that ESG screening affects valuations, risks and performance of underlying indexes. Strong ESG companies typically exhibit above-average risk controls and compliance standards. Because of the better risk-control standards, companies are less prone to severe incidents such as fraud, embezzlement and litigation, among other issues. Companies with less frequent and less severe risks, tend to have less stock-specific tail risks. 

Companies with a strong ESG profile are more competitive than their peers, with a more efficient use of capital, better human capital development, and better innovation. Strong ESG companies use their competitive advantage to generate better returns which leads to higher profitability, and higher profitability results in higher dividends.

Companies with a strong ESG profile are less vulnerable to systematic market shocks and therefore show lower systematic risk. Lower systematic risk generally means that a company has lower beta and therefore investors require a lower rate of return. This translates into a lower cost of capital, which ultimate may lead to higher valuations.  

Selecting the right strategy 

With the breadth and depth of strategies available, the challenge for advisers and investors is selecting the right strategy. There is a great deal of variability in the screening methodologies used. Consider the following checklist:

  • Do you gain exposure via an active or passive strategy?

  • What has been the experience of the portfolio management team?

  • How long have they been managing ESG/sustainable portfolios?

  • How do they screen and weight securities?

  • What has been the historical track record?

As the data show, investors can do good and do well — but they may need help in selecting the right strategy. ESG screening helps identify companies with strong policies and practices. Individual investors may want to elicit help from a trained adviser who can help with the nuances of sustainable investing. 

Also read: Developing an ESG scorecard

Above: Sun over Lake Hāwea, Otago, New Zealand. Photo: Michal Klajban/Wikipedia.