You don’t have to “give up” performance when integrating ESG
You don’t have to “give up” performance when integrating ESG
Key takeaways:
- Environmental, Social, and Governance (ESG) can benefit single-stock returns. Evidence shows that shares of better-quality companies can perform better than inferior peers.
- ESG can benefit portfolio risk and return. Evidence shows that integrating ESG into the investment process, and investing in companies with better ESG scores, can add to performance.
- ESG integration can lead to lower risk. Evidence shows that ESG analysis can help deliver a similar return while reducing investment risk.
There remains considerable debate around the risk/return implications of integrating ESG considerations into investment decisions. These concerns often centre on the belief that investors must give up' performance when integrating ESG.
That's why we looked at the results of studies spanning different time periods and regions (including emerging markets) to try and get some answers.
While this is not an exhaustive review, we have tried to include analyses that are rigorous and robust, with an emphasis on peer-reviewed academic research.
Part 1. Does investing according to ESG principles mean sacrificing returns?
ESG and corporate financial performance
We reviewed research papers published in the Journal of Sustainable Finance & Investment, in the Journal of Portfolio Management and by the NYU Stern Centre for Sustainable Business (itself a meta-study that reviewed more than 1,000 research papers).
They arrived at the conclusion that higher-quality companies, defined as those with better ESG ratings or scores, perform better on a fundamental basis i.e. in terms of corporate financial performance (CFP).
This fundamental performance could relate to, for example, broad-based profitability, return on equity (ROE), return on assets (ROA), or dividend payments.
ESG and company stock returns
We looked at studies of companies listed in the US, UK, emerging markets and elsewhere. They showed that:
- ESG quality is associated with lower volatility, and therefore lower risk, and consequently higher risk-adjusted returns:
- High-scoring ESG stocks have lower volatility and betas (i.e. systematic risk) than lower-scoring ESG stocks;
- Companies in both developed and emerging markets with higher ESG scores generally experience lower costs of capital when compared to those with poorer ESG scores:
- ESG integration can aid investors in China, with high-scoring ESG portfolios outperforming low-scoring ESG portfolios in normal circumstances, and especially during market turbulence
Portfolio research and implications
It's tempting to focus on what ESG can add to portfolio performance. However, equally important is the impact of ESG on a portfolio's risk exposure.
We think in terms of risk-adjusted returns: if two portfolios deliver the same return, the one with lower volatility would have higher risk-adjusted returns (i.e. it returns more per unit of risk).
Once again, our review of the research suggests that:
- ESG integration reduces portfolio risk across the full spectrum of markets and investment styles;
- Incorporating ESG criteria into portfolio construction may help to limit market risk.
What is ESG quality, significance of materiality
So far, we have equated good ESG scores with ESG quality. But our experience teaches us that it is risky to consider ESG scores as the definitive view of a company's ESG quality.
Investors need to understand the “materiality” of issues - their business impact on a firm - and interpret the ways in which a company is addressing material risks and opportunities.
Some issues will be more pronounced, and present greater risks and opportunities, for firms depending on where, and in which industry, they operate.
Part of the challenge of ESG is determining what is material for a company. Focusing on “strong” performance by a company on a non-material issue can give a misleading view.
A 2015 Harvard study found that firms which perform well on the ESG issues most material for themselves can out-perform those that don't. Meanwhile, firms with strong performance linked to immaterial sustainability topics, do not outperform those with poor performance on immaterial topics.
Part 2. Implications for active management
Macro, thematic-level ESG research
Look to understand major themes and trends in ESG and understand how they might affect firms. Our views on ESG build on the “4Ps”:
- People (including demographics);
- Policy (including governance and engagement);
- Planet (including environment and climate change);
- Progress (including technology and infrastructure).
Specific topics may include: decarbonisation; sustainable products changing consumer preferences; supply-chain management; and financial inclusion.
Firm-level ESG research
Understand the ways in which management is addressing and managing ESG issues, and embed this into the core research process to help build a view of the quality of a company.
Whatever research you may use, do your own due diligence and research to build as full a picture as possible. Behaviour and practises can be better (or worse) than disclosures might suggest, and so, relying only on company disclosure when assessing ESG does not provide the whole picture.
Help companies improve and enhance their ESG through active engagement. If there is a link between ESG scores and performance, then improving ESG scores (either by influencing behaviour or simply improving disclosure) may help stock, and hence, portfolio performance.
We believe that companies that are well-managed, and which consider long-term risks and opportunities around ESG issues, should outperform over the long term.
And finally...
ESG can have a very positive effect on both corporate financial performance and on portfolios. We believe that companies that are well-managed, and which consider long-term risks and opportunities around ESG issues, should outperform over the long term.
There is evidence across many time periods and regions (especially in emerging markets) that integrating ESG into the investment process, and investing in companies with better ESG scores, can add to performance.
Top 4 investment ideas
Here's a list of investments that Millennials can relate to:
Unit Trusts
A unit trust allows access to different markets at only a fraction of the cost with the help of professional fund managers.
RoboInvest
For the discerning investor, RoboInvest has 36 thematic portfolios to choose from, from Electronic Vehicles and US Tech to Singapore REITs.
Amundi Funds Asia Income ESG Bond
OCBC exclusive fixed income fund that aims to provide regular income and invests in Asian markets with a focus on ESG.
Retirement
OCBC Life Goals – a comprehensive retirement planning tool that simulates the amount required for a financial goal and offers a seamless product purchase journey and goal tracking.
*The survey conducted online over a month from mid-August this year, polled 2,051 working adults in 24 indicators under 10 categories, including saving and spending habits, managing of debts, investments, and retirement planning.
You can easily access the Sustainability Hub via your OCBC Digital app.
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