In recent years the growing demand for financial products with an eye on sustainability has turned Responsible Investing from representing a small niche into a global investing trend. Along with this, Environmental, Social and Governance (i.e. ESG) indicators have gained popularity among investors because they can meet two goals at the same time: reduce a portfolio’s risk exposure and improve its efficiency. However, ESG seems not to be enough to make an investment strategy by itself. Our experiments show that although it does not hurt historical returns, ESG-screened portfolios lead to very similar results in terms of risk, performance and correlation.
Rather, ESG appears to be a consistent and solid starting point to design a well-rounded investment approach to put performance and sustainability together. So we ask: what do we need to turn values into value?
Introduction
In recent years, themes like climate change, pollution, natural resource scarcity and population growth caused a fundamental shift in the way investors think about their investments. In this sense, it has become evident that social and environmental risks are indeed investment risks and therefore they represent an additional source of value-creation or destruction. So, keeping an eye on sustainability can help achieve two goals at the same time: reducing a portfolio’s risk exposure and improving its overall efficiency.
Along with this, an increasing share of institutional investors is committing to this transition by innovating their product and service offering. Not surprisingly, in his latest annual letter, Larry Fink, CEO of Blackrock – the world’s biggest asset manager with almost $7 trillion of AuM – explained that sustainability will be at the forefront of his company’s new standard for investing. In particular, he further added, this decision marks a pivotal step in ensuring that in the next future the company will be able to operate sustainably with its entire set of stakeholders.
Indeed, the potential link between ESG indicators and financial performance opens to the existence of material benefits for companies. For example, performing well in environmental factors could signal a more efficient use of resources, or having high social and governance scores could be an indicator that the management and stakeholder interests are indeed aligned with the firm's overall objectives.
As a result, investors are going through a profound reassessment of what are the drivers of risk and value, adding to their traditional toolbox new ways to assess the long-term prospects of a company. Among this, non-financial data and especially ESG indicators have become an increasingly popular solution to factor in the externalities (i.e. direct or indirect consequences of industrial activities) that come from running a business.
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200 Years of Responsible Investing
Taking ethical and social considerations into business-related decisions is not a new thing. Its roots date back as far as the 18th century when, for example, the members of religious groups prohibited their members from participating in the slave trade business.
Indeed, from the public offering of the famous Pioneer Fund in 1928, which excluded from its investable universe tobacco and alcohol companies, to the 1971 PAX World Fund that excluded firms whose profits came from weapon production, there have been many examples that featured a more wide and holistic approach to investments.
In this sense, before entering massively into our current investing doctrine, forms of Responsible Investing have always been out there, with the difference that nowadays we have better instruments, knowledge and information that can make the difference. Fast forward to the present day, we see that investors’ adoption of Responsible Investments has dramatically exploded.
The table shown in Exhibit 1 makes it clear: according to the data presented in GSIA’s 2018 report entitled “Global Sustainable Investment Review”, assets under management in sustainable investment products grew from $18.3 trillion in 2014 to $30.7 trillion in 2018, growing annually by more than 20% each year.
In addition, we could further look at its geographical breakdown. Indeed, from Exhibit 2 we observe that the scale of the sustainable investing market differs greatly from region to region. From this, we see that Europe is still the biggest market for sustainable products, although in recent years we have also witnessed the US and Canada grow massively with above-average growth rates. Indeed, if we move from relative to absolute values, we see that the US market has almost doubled in size since 2014 to about $12 trillion.
What is ESG?
However, Responsible Investing is a term that refers to a very broad universe composed of several dimensions, namely: Socially Responsible Investment (SRI), Sustainable Investment (SI), and Environmental, Social and Governance (ESG) Investment.
In this sense, when we talk about SRI we are referring to the application of ethical as well as financial considerations when making investment decisions (e.g. excluding sectors or industries from the investable universe). Differently, SI refers more specifically to investments that offer financial returns benchmarked and measured against metrics of social impact (e.g. green bonds).
Ultimately, the term ESG refers to a set of variables that are used to assess the environmental, social and governance levels of a firm, emphasizing their informative value to assess a company’s long-term sustainability prospects.
Indeed, evaluating companies under the ESG lens is not an easy task and does not translate into a binary inclusion or exclusion decision.
On the contrary, it needs to weigh simultaneously many factors among which: the sector to which the company belongs, the variables in which it is scoring high or poor levels, their impact on financial performance, as well as the future prospects of the company to grow in a more sustainable business.
As a result, ESG introduces a new (and deeper) perspective to determine if a company is likely or not to provide long-term, risk-adjusted and sustainable results to its investors based on the assessment of three value-creation pillars: Environmental, Social and Governance.
For instance, Exhibit 3 lists a set of commonly used - yet not exhaustive -variables to look for in an ESG analysis to monitor a company’s sustainability level.
Sustainability, Performance and Risk
During the years, the interest in researching the relationship between ESG and financial performance has grown a lot. In particular, there is an increasing share of studies that are highlighting a positive link between them. These findings hint at the fact that ESG could play a concrete role in portfolio management, a role that exceeds its ethical considerations and that instead sheds light upon a new complementary dimension for investors to evaluate the expected riskiness and performance of a company.
Risk Management
To date, the academic literature that specifically addresses the relationship between ESG and the risk of a security is thin. However, recently it has been populated by some important works that have contributed to shed light on this aspect.
In 2018, Dunn et al. have found strong statistical evidence between companies’ ESG profiles and stocks’ risk measured by its Beta coefficient: stocks with best-in-class ESG scores have been found to present lower Beta values, and therefore systemic risk.
In addition, in 2019, Lööf and Stephan noticed that firms with positive changes on their ESG Ratings showed a reduction in their financial downside risk (i.e. the risk of extreme negative returns occurring). In the same year, Goldberg and Mouti carried out several experiments to forecast the maximum drawdown (i.e. the peak-to-trough decline in cumulative return over a specific period) of US equities, finding out that not only ESG scores provide a significant improvement of the predictive power of models, but also that companies with higher ESG scores were more likely to have lower drawdowns.
Expected Returns
On the expected return side, we also observe a great heterogeneity in the results obtained in academic studies. Among them, several studies like the one conducted by Khan et al. in 2015 have shown a positive relationship between them.
Indeed, by looking at a set of material ESG issues that affect the performance of a company (e.g. waste management, data security, diversity and inclusion, product safety, etc.), they found out that companies that scored high in those areas were more likely to generate superior returns.
However, other studies like the one of Fabiozzi et al. in 2008, and the one from Benanni et al. in 2018, have added more dynamics to this phenomenon, pointing out the existence of a U-shaped relationship between ESG score and financial performance meaning that both best-in-class and worst-in-class ESG stocks have tended to outperform common market benchmarks during the past years.
Navigating the ESG Ocean
In this light, what appears to be of paramount importance to asset and investment managers that face ESG integration within their investment process is having a thorough understanding of the data that they will deploy in their analysis, among which:
- How is this data calculated?
- What information does it embed?
- Does ESG add value to the investment process?
- What is the most efficient way to integrate ESG data?
At a higher level, it is important to distinguish that ESG data can be sourced at different levels of granularity, depending on what is the final output that needs to be achieved.
Nevertheless, a big share of the current market is represented by ESG ratings, that is, a numeric score - usually calculated by rating agencies or index providers - that aggregates data at a company-level to express the degree of the environmental, social and governance sustainability of a firm.
ESG ratings can be a useful tool since they serve as a synthetic proxy to select and identify sustainable investments according to an objective criterion: for example, by sorting securities by their ratings, an investor can easily assess best-in-class stocks and integrate such information into his investment process.
As we can see from Exhibit 4 though, the landscape for ESG data is anything but uniform: providers use proprietary methodologies for assigning company-specific ratings, causing some discrepancies. Indeed, investors should look beyond the basics of ESG ratings and focus on the reasons why they tend to be different.
On this topic, a recent paper from Research Affiliates written by Li and Polychronopoulos has put emphasis on how the use of different ratings could lead to different investment outcomes. Indeed, following the framework introduced by Berg et al. that has analyzed ratings coming from several ESG providers, we have a clear way to disentangle those differences, namely: measurement issues (i.e. what metrics are used to assess different ESG attributes), differences in scope (i.e. what attributes are being assessed) and finally differences in the weight attributed to each pillar (i.e.the level of materiality the rating provider assign to each attribute).
For the above-mentioned reason, a thorough and in-depth analysis of the data provided and its construction methodology is essential to have a clear picture of which information is really taken into consideration and what is the potential effect it could have on the overall investment process.
Putting ESG Data to Work
On top of the previous argument, there is another reason why integrating ESG data can be a challenging task for asset and investment managers: effectively finding, capturing and deploying the signal hidden in the noise of data.
Indeed, this challenge appears to be threefold: first, as previously mentioned, there is the need to conduct a thorough and in-depth analysis of the raw data sourced and of how the information collected at a company level is represented.
Secondly, there is an increasing need to put it efficiently to work, that is, to find an effective and scalable solution to find the investment signal hidden in all the noise of data and process it correctly.
Lastly, there is the need to put the processed and cleaned signal into an actual investment strategy and therefore, to find the appropriate methodology to correctly represent it into the investment decision-making process.
So, given the variety of the ESG ecosystem, during the years several ways have emerged to integrate ESG data into the investment process. However, as their efficacy and performance tend to vary greatly according to the real-world investment needs and objectives, those techniques are often used in combination with each other. Exhibit 5 presents a review of the common ways that have emerged to integrate ESG data.
An Example: The S&P 500 Index ESG-Screened
In order to evaluate the possible benefits of investing only in stocks with a high ESG rating, we investigated the performance of different baskets obtained from the application of different filters on the ESG rating.
So, we took the data from the S&P 500 index in the last five years and created three different cap-weighted portfolios using respectively the best 70%, 50%, 30% of the stocks ranked according to their Sustainalytics ESG score. The results are shown in Exhibit 6.
By looking closely at the data shown in Exhibit 6 we immediately understand the behavior of an ESG-based portfolio. Indeed, as we see from the above plot, all the ESG-screened portfolios keep the same trend as the underlying benchmark.
This hints to the fact that ESG on its own does not yield dramatically different investment outcomes with respect to investing in the underlying market. Instead, filtering out its best-in-class stocks at different thresholds has a slight amplifying effect on the market fluctuations.
Yet, we can make a further observation: that although ESG does not create value as a standalone investment strategy, neither it harms its historical returns. As a result, this means that it can be used as a building block for further improvements over the standard cap-weighted strategy. Moreover, this is also a clear sign that the ESG-screened portfolios remain well-diversified portfolios and that we can achieve almost the same returns as we were investing in the broad market.
Is ESG Not Enough?
As Responsible Investing continues to grow, ESG has effectively stopped being a niche segment and has instead become a global trend of the asset management industry. Indeed, more ratings and more disclosure are making it possible to integrate ESG data directly into the investment process, but not without proper consideration.
Indeed, asset and investment managers should pay attention to how they embed ESG data into their analysis. It is essential to have a plan to extrapolate correctly the signal that arises from the environmental, social and governance profile of a company, and effectively integrate this information into profitable investment solutions.
However, ESG by itself may not be enough to provide better investment results. Instead, by looking at the analysis we conducted on the S&P 500 stocks, we have seen how an ESG-oriented approach is rather a robust approach that does not destroy value and yields investment outcomes that are mostly in line with broad market performance.
To complete the puzzle, we need one last piece: to put and rethink ESG at the center of the investment process, as the starting point and a solid building block on top of which we can build better investment strategies to put together sustainability and efficiency.
