Steps remain to fully integrate ESG

All investors seek the same thing: superior risk-adjusted returns. And in recent years, the integration of environmental, social and governance information into investment decision-making and portfolio construction has become a viable route to achieving that goal. Through ESG, we see things more clearly without having to give up anything.

However, several investors are demanding more quantitative studies on the link between ESG and risk. Is there a difference in the average of the standard deviation of stock prices of companies with good ESG ratings vis-a-vis stocks with bad ESG performance? Is it possible to quantitatively demonstrate this difference, and establish that ESG firms bear less risk compared to non-ESG stocks? And, critically, since lower risk has traditionally meant lower financial returns, how can ESG investment really be a viable investment strategy?

A new study conducted by Granito & Partners in collaboration with Madrid's IE Business School has shed light on this issue. Just published by the Journal of Sustainable Finance & Investment and available on Granito's website, the study relied on the Dow Jones Sustainability index, one of the oldest and most recognized indexes in the field of ESG, to identify 157 companies that have good ESG performance. To contrast, and in order to bring statistical significance to the results, it randomly selected a greater number of companies — 809 — that are not listed on the DJSI. As the materiality of the ESG factors is highly related to the industry in which the firm operates, the study grouped equity stocks into 12 industries. The authors of the study are N.C. Ashwin Kumar, Camille Smith, Leila Badis, Nan Wang, Paz Ambrosy and Rodrigo Tavares.

Huge difference

The results are striking. In all 12 industries studied, the group of ESG companies listed in the DJSI, shows lower stock return volatility in comparison to the reference companies — on average by 28.67 percentage points less. But risk varies according to industry, with a stronger impact in materials, banking, energy and technology. The difference ranges from 6.1 percentage points (for food and beverage) to as much as 50.75 percentage points (the energy industry). This difference of percentage is a risk premium that the reference or non-ESG companies face and that investors should take into consideration when making investment decisions. (Risk was calculated using Sharpe and Treynor ratios.)

In contrast to conventional thinking in which lower risk means lower return, the model shows that even with a lower risk, the investment could achieve a higher equity return. The majority of the industries that were studied (eight of the 12) resulted in better returns for ESG companies than their peers — ranging from 2.25 percentage points to 31.84 percentage points higher. Across all 12 industries, the positive effect on equity return is 6.12 percentage points higher for ESG companies on average. And, if one looks at only the eight industries with clearly higher ESG returns, this difference jumps to an average 14.08 percentage points for ESG companies compared with their peers. The industries of energy, food and beverage, and health care show the highest advantage regarding the positive impact of good ESG practices on the stock return (lower risk and higher return). It becomes clear, therefore, that ESG factors give investors a more complete picture of business opportunities, reducing risk and improving alpha.

More support

The Journal of Sustainable Finance & Investment study, which is focused primarily on the correlation between risk and ESG, complements an array of other studies centered primarily on the correlation between returns and ESG. These were published in recent years by the Harvard Business School,Cambridge Associates and the Global Impact Investing Network, Allianz Global Investors and many others. All demonstrate that integration of ESG factors brings higher returns. Given the fact that a recent survey by RBC Global Asset Management showed many investors remain uncertain about the ability of ESG investing to drive investment performance and mitigate risk, studies like these will help clear the path.

Mainstreaming ESG

In a few years, ESG integration will likely become a routine asset management practice. But a few steps still need to be taken.

Fiduciary duties. Despite recent recognition by the U.S. Department of Labor and The Pensions Regulator in the U.K. that ESG is a proper component of the fiduciary's analysis, more regulatory and policy work needs to be done to establish a common, global agreement on the necessity of including ESG in fiduciary duties, as stated in a report by the United Nations-supported Principles for Responsible Investment.
Investment strategies. ESG is a good fit for some asset classes and investment types (public and private equities, fixed income), but we need more of a track record for others (hedge funds, venture capital, commodities). According to a 2016 survey by Unigestion SA, 53% of hedge fund managers showed no interest in ESG. Microsoft has recently taken an important step supporting an ESG venture capital fund in Brazil, one of the first in the world, but Silicon Valley is still detached from ESG issues.
Investment horizons. There is a potential mismatch between long-term investing associated with ESG and short-term investment strategies. Although institutional investors prefer the first, ESG should become relevant also for the latter in order to cover the full spectrum of investment time frames.
Data. Investors and financial analysts need more training and better instruments to extract ESG data from assets. Qualitative assessment of integrated reports along with quantitative data by service providers such as MSCI, FTSE4Good or DJSI are very useful, but ESG — just as fundamental analysis — needs to be able to develop machine learning and artificial intelligence tools to ensure more sophistication and precision.
Alphabet soup. Just as in any other emerging field, we have been too prone to create terms to coin specific phenomena or practices. Presently, there is no terminological consensus between “ESG investing,” “socially responsible investing,” “sustainable investing,” “impact investing” and so on. Different players demarcate borders differently. Lack of universality hinders mainstreaming.
Standardization. Just like professional accounting standards, companies should be able to communicate their ESG performance in a standardized and universally accepted fashion. The Sustainability Accounting Standards Board is a step in the right direction, but the mission is not yet accomplished.
Managers. The staggering growth of ESG investing has outpaced the training of managers on ESG-related issues. In 2016, 37% of institutional investors incorporated ESG factors into their investment decisions (up from 29% in 2015), according to a Callan Associates survey. There is, therefore, a need to have more money managers that have an ESG sound analytical knowledge with processes in place. For a few months now, the CFA Institute has been giving ESG expanded weight in its exam, but a lot more emphasis should quickly be put globally on training.
Universalization. The rhythm of ESG growth varies according to regions. ESG investing represented $8.72 trillion, or one-fifth of all investments under professional management in the U.S. this year, an increase of 33% since 2014, according to the US SIF 2016 report. Europe is equally high. But figures are much lower in Asia, Africa and Latin America.

Adding ESG to fundamental analysis is akin to presenting magnetic resonance imaging to medical practitioners used to X-rays. It is likely a game-changer in the way we operate in capital markets. But we have to be careful and creative in order to capture its full potential. The years ahead will be decisive.

 

Article published originally in Pensions & Investments.