THERE has been a lot of talk about ESG investing recently. Financial institutions have been marketing ESG investments aggressively to attract funds, and there are expectations that ESG investing is the future and will do well.
While it is always exciting from a business perspective to quickly launch the latest theme of the month or year, we took time to research these investments to find out whether ESG investments are mere marketing fluff or if ESG investing does gives you a higher expected return.
ESG investing refers to the use of environmental, social and governance factors to evaluate companies and countries on how far advanced they are in terms of sustainability. Once enough data has been acquired on these three metrics, they can be integrated into the investment process when deciding what securities to buy.
In order to make an informed decision on whether ESG investing is for us, we first need to consider the impact of ESG investing on the long-term investment portfolio's risk and return. Secondly, we need to examine the broader impact of ESG investing on the overall well-being of society beyond pure investment risk and return. Due to limited space, I will just highlight a few of our key research findings.
Impact on risk and return
NYU-Rockefeller looked at the research on relationship between ESG and financial performance, reviewing over 1,000 papers from 2015 to 2020. In studies focused on company specific metrics, there appears to be a positive result on return on equity, return on asset or stock price when a company focuses on ESG.
But for studies which focused on whether fund managers are able to consistently pick outperforming companies based on ESG screens, the result is less conclusive. ESG-focused investments outperformed in less than 35 per cent of the studies.
Researches
In another research, Dimensional Fund Advisors took a look at companies' emissions across the US, developed ex-US and emerging markets, and concluded that emission intensity, emission level or change in emission level do not provide any additional information about the future profitability of a company beyond what is reflected in current profitability.
This suggests that we may not be able to conclude that companies with low emissions can generate a higher expected return. Even if they can, we cannot accurately predict and pick these companies consistently.
In Vanguard's research, Plagge and Grim looked into the returns and volatility of US listed stocks over a 15-year period (2004-2018) and compared them with the FTSE USA All Cap Index. They considered index and active funds; and funds that avoided companies with poorest ESG rankings and those that picked high ESG scorers. It found that ESG funds have neither systematically higher nor lower raw returns or risk than the broader market.
While our research shows that there is no direct link between ESG investing and risks and returns, how well an ESG portfolio will do may depend on how the investment process is implemented. This is because, an ESG consideration is similar to adding an investment constraint to a portfolio which inevitably results in added costs and or a reduction of diversification (as there will be fewer securities in the portfolio).
In other words, ESG investing may not improve or reduce a portfolio's return; but the ESG implementation will likely be costly, thus ultimately reducing the portfolio return.
Our research so far reveals that:
1) we cannot conclude the ESG companies will give a higher expected return.
2) Fund managers using ESG strategies as their mandate may not consistently deliver higher or lower returns and risks.
3) Cost of implementation matters. One reason for the difficulty in assessing the impact of ESG is there are many different ways to assess ESG.
Challenges
To highlight the challenges, we look at two major ESG data providers - MSCI ratings and Sustainalytics (Morningstar). The accompanying table highlights the similarities and differences in how they rate companies on ESG.
Ignoring some jargon, it is evident that the two rating agencies have different weights for the G aspect. MSCI has separate weights for each of the E, S and G pillars while Sustainalytics considers ESG together. These differences alone, which are also somewhat qualitative, highlight the challenges of finding consistent data for analysis.
Our research tells us that if we make an ESG-related investment hoping to get a higher expected return, we may be disappointed. Instead, we should look beyond financial return and examine impact instead.
It is this reason that has prompted us to offer ESG investments to our clients. At the heart of ESG investing is the promotion of positive societal impact and corporate responsibility - hopefully without compromising financial returns.
Embedded in Providend's purpose statement are these two statements: "We exist to serve our families of clients to fulfil their dreams and achieve their life purpose by providing them with honest, independent and competent advice. We seek to inspire our clients to first make life purpose decisions before making financial decisions."
Offering ESG investments is a natural outflow of our desire to positively impact the world. Space constraint does not allow me to elaborate more on the research, but we are hosting a series of three ESG webinars next week. ESG investing is potentially a way for you to express your values rather than to get higher expected returns.
For advisory firms, if we are measured on our ESG metrics, how would we fare? If we do badly, then offering such investments may just be a "theme of the month" product offering. There may be a disconnect between what we do and what we truly believe in.
- The writer is CEO, Providend Ltd, Singapore's first and probably sole fee-only comprehensive wealth advisory firm. He can be contacted at chris_tan@providend.com
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