Sustainable Investing (Part 2)

A myth exists that pursuing a sustainable investment strategy can be costly to implement for the following reasons:

Returns are lower than conventional investment strategies
Manager costs are higher
You lose the benefits of diversification

Part 2 of our Sustainable Investing article looks at research on the investment performance of sustainable strategies.

Research on Performance

With 15 years of data at most, we are decades away from conclusively determining if sustainable investing offers a higher, lower or similar return as conventional investing. However, there is a vast amount of research on ESG investing already to help us understand the potential performance implications. There are three types of performance studies relevant for investors.

Study 1 – Company Level studies

Company level studies research whether companies where managers make sustainable decisions have better corporate financial performance and better stock market performance.

In 2015, the University of Oxford’s Smith School of Enterprise and the Environment teamed up with Arabesque Asset Management to review 200 academic papers in a meta-study entitled “From Stockholder to Stakeholder.” The report researched the economic results of ESG practices by corporate managers and the implications for investors. The report observed three key points:

90% of the cost of capital studies show that sound ESG standards lower the cost of capital of individual companies
88% of the studies show that solid ESG practices result in better corporate operational performance
80% of the studies show that company stock price performance is positively influenced by good sustainability practices.

The study also found active ownership allows investors to influence corporate behaviour and benefit from improvements in sustainable business practices. It concluded that it is in the best interest of investors and corporate managers to incorporate sustainability considerations into their decision-making processes. Companies that behave as better stewards of people and planet have improved corporate financials.

However, there are two opposing forces at work here. When a company lowers its cost of capital, the expected return of the company also reduces as it becomes a less risky investment to hold. Conversely, a better run company can avoid pitfalls that may help increase profits over time. We will need more data to conclude how these competing forces influence stock prices, however a 2019 study by Bank of America showed that 90% of companies in the S&P 500 that declared bankruptcy from 2005 were below average on environmental and social scores[i].

Study 2 – Index Level studies

Index level studies inform the investor if an ESG index has a performance differential to a conventional market index.

Index comparisons isolate the question to whether a sustainability-oriented basket of companies has any systematic performance difference to a basket of all companies. Many index providers now have ESG or sustainability versions of their flagship indices. MSCI has 140 + sustainability indices across its product range. A comparison between the conventional benchmark MSCI All Country World Index (ACWI) and the new MSCI ACWI ESG Leaders Index shows similar returns over the past 13 years, with ESG inching ahead in the past 12 months primarily due to Energy stocks being the worst performing sector of the stockmarket.

Study 3 – Fund Level studies

Fund level studies are perhaps the most practical as they reflect what investors can achieve in their own portfolio returns.

Taking a portfolio view to evaluate performance, Deutsche Bank partnered with the University of Hamburg in 2015[ii] to review 2,000 academic papers and found that the business case for ESG investing is empirically well-founded; they concluded that ESG indicators pay off financially and appear stable over time.

The review uncovered that 62.6% of studies examined show a positive correlation between integrating ESG factors and portfolio performance. The study found that environmental and social issues vary in materiality across industries, but governance issues are integral to the proper functioning of all companies. For instance, where there is a lack of oversight on governance issues, there is potential for reputational risk and financial damage. Another conclusion was that it is more beneficial to apply the E, S and G independently, rather than together. The study also found similar performance links with ESG factors in bonds and real estate as well.

It is difficult to find an ESG fund with a conventional equivalent fund and a reasonable timeframe to directly compare what return actual investors would have received by adopting either approach.

The fund with the longest data series we could identify is the Dimensional US Sustainability Core 1 Portfolio, which commenced on 30 April 2008 at the request of a US based advice firm who had a strong focus on Sustainable Investing. This fund has ESG overlays whilst the directly comparable Dimensional US Core Equity 1 Portfolio does not.

The performance of these two funds over 11.5 years to 30 September 2019 (net of expenses and including dividends) was[iii]:

US Sustainability Core 1 Portfolio: 9.61% pa

US Core Equity 1 Portfolio: 9.62% pa

If we extend the timeframe to 30 September 2020, the sustainable fund results improve significantly relative to the conventional fund with annual outperformance of 0.38% pa:

US Sustainability Core 1 Portfolio: 9.96% pa

US Core Equity 1 Portfolio: 9.58% pa

We used these two differing end dates because Energy was the worst performing sector during the pandemic (down 40% over the 12 months to September 2020), so we didn’t want this event alone to skew the results.

Robeco is another research-driven global fund manager who has been employing ESG routinely across their bond and equity portfolios since the 1990s. Every year, a dedicated team of Robeco specialists engage in active dialogue with around 200 companies and 70 private equity managers to discuss financially material themes and update their proprietary sustainability database.

Robeco finds little point in assessing the CO2 emissions, water use or paper consumption of banks, as there is no link between these environmental factors and the banks’ long-term business models. Instead, they analyse banks’ corporate governance, risk management processes and cybersecurity measures. For a utility or energy company, however, CO2 emissions are extremely important indicators, as they can have a major impact both on their long-term business models and society at large. After the application of the evidence-based factors to their portfolios, Robeco then ensure the total weighted sustainability score is at least as high as the reference index.

The performance of two Robeco Australian funds over three years to 30 September 2020 (longest live data set available) again shows ESG did not negatively impact returns:

Robeco QI Global Developed Sustainable Enhanced Indexing: 5.94% pa

Robeco QI Global Developed Enhanced Indexing: 5.93% pa

Over the live data period we have available, there was no cost to investors who have pursued a sustainable approach – indeed, they’ve come out slightly ahead.

Some still require more convincing

As noted above, the data set for reviewing the performance of sustainable strategies is no where near as large as for conventional investing, and some academics are yet to be convinced of the results.

Professor Aswath Damodaran, Professor of Finance at the Stern School of Business at NYU, recently concluded the following[iv]:

“There is a weak link between ESG and operating performance (growth and profitability), and while some firms benefit from being good, many do not. Telling firms that being socially responsible will deliver higher growth, profits and value is false advertising. The evidence is stronger that bad firms get punished, either with higher funding costs or with a greater incidence of disasters and shocks. ESG advocates are on much stronger ground telling companies not to be bad, than telling companies to be good. In short, expensive gestures by publicly traded companies to make themselves look “good” are futile, both in terms of improving performance and delivering returns.”

“The evidence that investors can generate positive excess returns with ESG-focused investing is weak…… it appears to me that just as likely that successful firms adopt the ESG mantle, as it is that adopting the ESG mantle makes firms successful.”

If the conclusion here is that adopting an ESG approach at least prevents a company from becoming a “bad” company, then that alone would appear to deliver benefits to shareholders.

Conclusion on Performance

Academics and practitioners have researched the effects of environmental, social and governance factors on the financial performance of individual public companies and appear to conclude, on average, ESG firms do better. They have also tested how indices of more sustainable stocks perform versus the benchmark indices, and there do not appear to be systematic differences. Studies have also measured how socially and environmentally responsible funds performed against conventional funds and found funds built on ESG factors tend to do a bit better.

As recent Morningstar study concluded, “there is no evidence that investors need to sacrifice returns when they invest in good ESG companies globally compared to bad ESG stocks”.

Investors who want sustainable investing with good performance can do so provided they act with care. All the fundamentals of successful investing, like remaining well diversified, staying disciplined and keeping costs low, still apply to sustainable investing.

Maintaining diversification

We have written many articles explaining the importance of diversification - https://www.stewartpartners.com.au/insights/2020/6/3/the-perils-of-owning-individual-stocks-more-losers-than-winners

It is possible to maintain strong diversification in portfolios whilst pursuing a sustainable investment approach. The table below shows the number of stock holdings in Stewart Partners core sustainable portfolios compared to conventional portfolios:

You expect a sustainable portfolio to look different to the market because you are screening out, or reducing exposure to, “bad” ESG stocks. The mix of stocks in an ESG portfolio is always changing as businesses review their practices. Some changes we’ve noted in ESG portfolios in recent times include:

Wesfarmers (Australian consumer staples) was made eligible for ESG funds in 2019 following their divestment of remaining coal assets
Propel Funeral Partners Ltd (Australian funeral services) was made ineligible for ESG funds following a large relative increase in greenhouse gas emissions

The tracking error of well-diversified portfolios that pursue evidence-based investment approaches is typically in the range of 1% to 6%, so the portfolios don’t look significantly different to the market.

Strategy Implementation

Our Investment Committee continues to review an increasing range of sustainability products for our clients to invest in. Importantly, we aim to retain the evidence-based principles and diversification in the sustainability portfolios we construct to ensure lifestyle and financial objectives are not sacrificed in the pursuit of sustainable investing.

As noted in Part 1 of this article, we adopt an ESG approach for clients who want to implement a sustainable investment approach. The primary screen applied is environmental (greenhouse gas emissions), and then social and governance overlays. The environmental overlays can achieve reductions in greenhouse gas emissions of 55% to 90% for current output and 100% reductions from reserves compared to a market portfolio.

Whilst the sustainable funds we use typically charge 6% -10% more than a conventional portfolio due to the additional due diligence applied to stock selection, Stewart Partners can still deliver a sustainable investment portfolio with total manager costs below 0.40% pa. The sustainable portfolio only needs to outperform the conventional portfolio by 0.02% to 0.05% per annum to cover the cost differential. When you compare this outcome with the Perpetual Ethical SRI Fund (which invests in Australian equities) which charges 2.28% for its retail fund and 1.18% for its wholesale fund, we think our outcome delivers compelling value for our clients.

Summary

It is clear to the team at Stewart Partners through conversations with many clients that the pandemic has brought the vulnerability and interconnected nature of our societies and industries to the forefront of thinking.

Sustainable ESG investing has been around for less than 15 years, so whilst the early signs on performance are positive, we will need more data before conclusively determining whether adopting ESG principles delivers a premium for investors. However, even for investors purely driven by profit, adoption of ESG principles is worthy of consideration.

More importantly, for investors whose personal values align with sustainable investing, sustainable principles can be adopted without appearing to compromise on net financial returns or your goals for your family’s future.

Author - Rick Walker, with thanks to our Global Association of Independent Advisors colleague Simon Brown at BPH Wealth (UK) for sharing his own sustainable investing research.

Please share this article with anyone you think would benefit from reading it.

If you have topics you’d like us to write about in the future, please contact me at rwalker@stewartpartners.com.au

[i] 5BofA Merrill Lynch. “ESG from A to Z: a global primer”. 2019. Available from: https://www.bofaml.com/content/dam/boamlimages/documents/articles/ID19_12722/ESG_from_A_to_Z.pdf

[ii] 25Deutsche Bank. “ESG & Corporate Financial Performance: Mapping the global landscape”. 2015. Available from: https://www.unepfi.org/fileadmin/events/2018/sydney/ESG-and-Corporate-Financial-Performance.pdf

[iii] Source: Returns Program

[iv] https://aswathdamodaran.blogspot.com/2020/09/sounding-good-or-doing-good-skeptical.html