Does ESG generate better returns?

When it comes to considering returns, ESG funds are relatively new and their performance is sometimes judged in the context of the bull market of the past 10 years, argues Steph Anthony.

There has been lots of debate on the inclusion of environmental, social and governance (ESG) considerations in investment strategies.

On the one hand, excluding certain companies (such as tobacco or oil producers) makes your potential investment universe smaller, so in theory, lowers the chance to outperform.

However, a number of academic studies contradict this. Some argue that incorporating ESG factors makes little difference to returns, while others claim that ESG actually improves returns (simply put, “good” companies are well run, and so outperform peers).

It has also been found that sustainable funds – those that have an ESG focus – have lower downside risk (meaning that they should lose less money in a downturn). This conclusion is supported by research from Morgan Stanley, by looking at data on nearly 11,000 mutual funds and ETFs from 2004 to 2018.

This does make some sense: when you incorporate a focus on company practices (especially governance) into your investment process, you are more likely to avoid the worst blow-ups.

But ESG investing is not straightforward and there are cases of “greenwashing”. Most notably, the “greenness” of many green bonds has been questioned. The European Union published guidance on green bond standards in June, but there is no legally binding definition – that is, a bond is deemed green pretty much because a company says so.

There have also been cases of high-profile index trackers not really excluding companies that you might expect them to. For example, an ETF might exclude companies that “own fossil fuel reserves”, but not oil services companies or refiners.

Most fund managers already make use of ESG factors, to some extent. No good manager is going to ignore the governance of a company when choosing whether to invest, or buy an energy company without looking at potential future regulation that might impact its revenues.

But having a clear focus on ESG – to have a portfolio with the objective of investing in companies that benefit society – is a personal investor decision. The good news is that the scope to do so is constantly increasing. So, do they actually generate better returns?

Despite a significant amount of research, there continues to be no clear consensus as to whether portfolios including ESG considerations generate better returns, risk-adjusted or otherwise.

A large part of this stems from there being no set definition of what “ESG” is – different investors will care about different environmental, social and governance issues and therefore sustainable portfolios vary widely in their nature. Even ESG ratings – a supposedly more objective measure – differ significantly depending on the provider.

Time frame is also key: many ESG funds have not been around for that long and so are only being judged in a certain economic environment (such as the bull run of the past 10 years).

That said, certain sustainable sectors have performed well, and are likely to going forward. For example, we hold a number of renewable infrastructure funds within the 7IM Sustainable Balance Fund that have performed particularly well over the past five years.  

The most important takeaway is that investors don’t have to accept lower returns in order to invest sustainably.

Different asset classes perform well at different points in time - having a diversified portfolio is key, and investors are able to do this in a sustainable way. 

Steph Anthony is an investment analyst at 7IM.

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