ESG investing beyond boom and bust

ASSETS allocated to ESG investments have accelerated in recent years. But reading headlines about environmental, social, and corporate governance (ESG) and performance can give you pause, if not whiplash.

One day it's "Better stock selection boosted ESG funds". The next day, it's "ESG investing looks like just another stock bubble".

So, which is it? Will ESG investment continue its ascent, or head for a bust? In 2021, we see both hype and scepticism giving way to a more nuanced understanding of when and how ESG has shown pecuniary benefits - and when it hasn't.

The ESG investing market is reaching a new maturity. The research has come a long way, and we know much more than we did even just a year ago. From concerns about over-valuation to why ESG ratings differ, the tools and analysis now exist for savvy investors to cut through conjecture and act on the evidence.

Let's start with that stock-bubble supposition. Some analyses have noted that "higher ESG" companies (arbitrarily defined) had higher valuations, raising concerns that the performance of ESG funds overall could be an unsustainable self-fulfilling phenomenon - effectively a price bubble.

But our own research showed little historical evidence of this when we focused on ESG approaches that integrated only financially relevant considerations. As with all things ESG, clarification of terms is a must.

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While the broad category of sustainable investments encompasses a range of both financial and non-financial investor objectives, ESG integration strategies typically seek a financial edge by directing more capital towards companies doing a better job of managing pecuniary ESG risks, often as reflected in their higher ESG ratings.

We compared companies with top MSCI ESG ratings (which are industry-neutral) against their bottom-rated peers over a study period from May 31, 2013, to Nov 30, 2020, looking at constituents of the MSCI ACWI Index. Over this period, the top third of companies by ESG ratings (re-sorted semi-annually) outperformed the bottom third by 2.56 per cent per year (1.31 per cent for the top third versus -1.25 per cent for the bottom third). Was this outperformance driven by a higher premium that investors were willing to pay, as ESG investments became fashionable? The short answer seems to be no.

Breaking down the factors that explain the performance difference, we found it was primarily driven by higher earnings growth of the higher-rated companies over this time, followed by the higher reinvestment return from dividend payouts and share buybacks.

Interestingly, the contribution from price-to-earnings expansion was a smaller explanatory factor, and even slightly negative for issuers with high ESG ratings. The findings corroborate our previous research that superior management of financially relevant ESG risks could have signalled greater competitiveness of companies relative to peers, translating over time into stronger profitability and ability to pay dividends.

These kinds of findings already go a long way towards clarifying the relationships between ESG information and financial performance. But there's more. Simplistic explanations for the performance of ESG strategies are just no longer tenable.

For example, 2020 saw a lot of conjecture along these lines: ESG outperformance is just due to avoiding the energy sector (which has suffered in stock-price performance during the recent cycle). But now new analytical tools can isolate the contribution of a specific ESG factor to explain performance, net of industry, country, currency and other equity style factors. These tools have shown that ESG factors have contributed more to explaining the performance of select MSCI ESG Indexes so far in 2020 than any other traditional financial factor - including exposure to the energy sector.

Nor is it still tenable to disregard all ESG ratings because different providers' signals are not well correlated. We often hear: If ESG ratings are not correlated, they must just be subjective noise and can't capture investment value.

But we now know that the financial significance of an ESG rating is highly sensitive to how underlying E, S and G issues are combined, so there is no need to give up on the entire concept.

In fact, a recent OECD report comparing ESG ratings from a range of providers found that most did not show positive correlation to returns, while one did show outperformance.

Further, MSCI demonstrated that different weights used for combining the exact same underlying E, S and G inputs led to significant differences (by between 7.4 per cent and 11.1 per cent) in how well an aggregate ESG rating ultimately captured stock market performance over the past 13 years.

Last but not least, wishful thinking hasn't held up consistently either. The common refrain here is that you can "do good and do well". That's historically been true more often than the naysayers think, but far from always. It is very clear that some investment strategies use ESG criteria that are not primarily aimed at improving financial performance - usually because they are trying to accomplish something else.

We see growing discipline among market participants to more explicitly distinguish what a given ESG strategy is targeting - and what it's not. A self-declared "sustainable" strategy, for example, might aim to do anything from aligning investments with a set of norms, such as the UN Global Compact or the Tobacco-Free Finance Pledge (typically implemented through exclusions), to targeting innovations that can solve an environmental challenge such as climate change (typically selecting companies from a narrow set of sectors).

These approaches, as with all approaches that do not aim to track the market, can underperform or outperform depending on the time horizon and market cycle.

Efforts such as the CFA Institute's initiative to develop a disclosure standard for ESG funds reflect the move among market players to better distinguish between these different "ESG features" that aim to meet different "ESG needs".

What does this all mean? With the demand for ESG and climate-related investment products on the rise, we think the market for sustainable investments is set to expand further. But investors no longer need to "believe" in ESG, or not. A sharper understanding is emerging as to which ESG approaches are financially relevant and which are more focused on social objectives, allowing investors to more precisely build their own strategies based on a track record.

A better-informed, cooler-headed ESG investment market ultimately paves the way for a more sustainable growth of inflows in 2021 and beyond.

• The writer is global head of ESG research at MSCI