Many investors today are increasingly looking at more than just risk and return in their portfolios – they are also hoping to make a positive “impact” with their investment dollars. This has led to an explosion in popularity in what is now the fastest growing category of investment style today: Environmental, Socially-responsible (or Sustainable) and Governance, aka “ESG” investing. According to the Global Sustainable Investment Alliance, the total size of ESG investments had grown to nearly $23 trillion by the end of 2016 and now represents more than 25% of all assets under management globally.
The practice of applying ESG screens to a list of potential investments can trace its origin back to the 1960’s (by excluding tobacco stocks or investments in South Africa, primarily) but has strongly entered public awareness in just the last few years. So what is ESG investing exactly? In short, ESG investing can be defined as utilizing environmentally-sustainable, socially conscious and corporate governance factors to target (or exclude) certain companies (or even entire countries) in a portfolio. Some examples of specific ESG factors include:
- Environmental Factors: Pollution standards, climate change (CO2 emissions), biodiversity, the health of oceans and fresh water bodies, organic farming and renewable energy.
- Socially Responsible Factors: Fair pay, exploitation of laborers (especially children), worker safety, product safety, diversity, animal welfare and human rights.
- Governance Factors: Executive compensation structures, monopoly pricing, ownership concentration, voting rights, lobbying, ethics and corruption.
Investors who are interested in this style of investing are often concerned that returns on ESG investments will be lower than on traditional investments. Given a diminished set of investment opportunities, is it reasonable to think that applying social screens will limit potential upside growth? Or put another way – does ESG investing affect expected returns?
Fortunately, we have several studies now that have examined this question and the answer is becoming clearer. From a quick review of the research papers to date, it appears that ESG factors are uncorrelated with other investment risk factors (such as size, value and profitability), and have actually been associated with enhanced returns, at least historically. In fact, one study found that early corporate adopters of sustainable policies enjoyed a 2.3% to 4.8% return premium annually from 1993-2010. The studies have also found that among the three factors, governance appears to be most correlated with higher returns.
While tantalizing, that level of enhanced performance is unlikely to be repeated as investors become more aware of ESG policies and market prices adjust accordingly. Moreover, many authors have cautioned that the significant implementation costs of pursuing an ESG strategy would likely negate any positive return impact for the typical retail investor. In other words, only professional investors are likely to be able to capture any enhanced ESG return premiums in excess of the additional screening and trading costs. But overall, the message for those interested in ESG investments is a reassuring one — there does not appear to be any reason to be concerned about lower returns when compared to traditional investment strategies. For those keen on making more impactful investments, ESG strategies can be safely incorporated into a well-designed investment plan.