Published: 14th May 2020 (5 Min Read)

Many investors, wishing to focus their portfolios on sustainable investments for ethical reasons, have an understandable concern that they may have to forgo (or dilute) long term returns. Happily, there is plenty of evidence to suggest that an Environmental Social and Governance (ESG) emphasis can in fact enhance financial returns.

Perhaps the most comprehensive research into the relationship between ESG and financial performance found that in around 90% of the 2000 studies that they reviewed the results showed that there was no negative relationship [1]. More encouragingly still, the majority of studies reported positive findings, supporting the belief that incorporating broadly ethical investments actually improves performance in the long run.

In a broadest sense, companies that practice good governance are probably well managed and therefore likely to be relatively successful.

Another explanation for these satisfactory returns is that the companies invested in for a positive impact on society or the environment are often small or medium-sized and at the forefront of innovation and new technologies; if successful this sort of business can perform exceptionally well.

A third, and more recent, explanation relates to the divesting by increasing numbers of investors of companies whose products might directly or indirectly increase carbon emissions or otherwise be seen to have detrimental effects on society or the planet.

Do investors have to accept higher risk (volatility) to achieve their ethical objectives? On the face of it you would think so – smaller companies, new technologies, and so on. Recent research illustrates that ESG does not impact all stocks equally [2]; perhaps not surprisingly the effect is most pronounced (positively or negatively) in the best or worst-in-class quartiles.

Further research shows that risk is reduced when ESG factors are taken into consideration, despite the reduction of diversification in portfolios [3].

In the US a recent Morningstar Landscape Report [4] showed that in 2018 63% of the U.S. sustainable funds sit in the top half of their respective Morningstar sectors, including 35% in the top quartile. Only 37% of the sustainable funds ended in the bottom half, with just 18% in the bottom quartile.

Another report by Morgan Stanley Capital International (MSCI) [5], using a different methodology, came to three broad conclusions:

  1. High ESG rated companies are more competitive and can generate abnormal returns, leading to higher profitability and dividend payments.
  2. High ESG rated companies are better at managing company-specific business and operational risks and therefore have a lower probability of suffering incidents that can impact their share price. Consequently, their stock prices display lower idiosyncratic tail risks.
  3. High ESG rated companies tend to have lower exposure to systematic risk factors. Therefore, their expected cost of capital is lower, leading to higher valuations.

It is reasonable to conclude that, provided stock selection is judicious and there is a prudent spread of risk, it is perfectly possible to make ‘profits with purpose’ and clients investing in a sustainable portfolio can expect at least to match the performance of broader markets.