Magazine Issues » September 2019

Inside view: Do investors have to sacrifice returns to invest responsibly?

Growing_plantJeroen Bos of NN Investment Partners says making a positive impact with esg principles can help boost financial returns.

Can responsible investing deliver environmental and social benefits as well as attractive financial returns, or are the two mutually exclusive? This is a question that many investors, both private and professional, have tussled with amid the burgeoning popularity of environmental, social and governance (ESG) investing.

However, as public awareness of responsible investment principles continues on the upward trend and funds specialising in the area gain longer track records, the assumption that returns must be sacrificed to invest ethically or sustainably is increasingly being challenged.

There is a growing body of evidence that suggests adding ESG insights to the investment process enhances rather than dilutes returns. In this article, we analyse four academic studies on this topic and summarise the most important objectives and findings.

Metastudy
Between the early 1970s and 2014, around 2,200 academic studies were carried out that investigated the relationship between ESG and corporate financial performance.

As the results were often contradictory, unclear or conflicting, Gunnar Friede, who is a senior fund manager at Deutsche Asset & Wealth Management, along with Timo Busch and Alexander Basse, professors specialising in investments for the University of Hamburg, decided to aggregate the results of these studies.

Their metastudy, published in 2015, gave compelling evidence that companies that do well on ESG criteria generate better financial results. It found that some 63% of the studies carried out over the 44-year period revealed a positive relationship between corporate ESG scores and financial performance. This trend has been relatively stable since the mid-1990s, but it is weakest for the social factor and strongest for the governance factor, the S and G of ESG, respectively.

A year after this research was published, investment advisory firm Breckinridge Capital Advisor and MIT Sloan School of Management, both US-based, conducted their own investigation to gauge the relationship between ESG and corporate fixed income propositions.

The most important conclusion of the joint study is that higher corporate ESG scores are compatible with narrower and more stable spreads in the corporate bond market. The spread between bonds issued by companies with the lowest and highest ESG scores is, on average, almost 200 basis points (or 2 percentage points).

This relationship strengthens when markets are under pressure and continues when they recover, so investors in companies with high ESG scores also seem to benefit from risk protection in falling markets. This could indicate that ESG is regarded as a measurement of quality.

However, the researchers also made several observations regarding their study. An ESG score is derived from information provided by the company itself – so companies that publish information have a better chance of scoring higher on sustainability, irrespective of the results of their sustainable activities.

It is a different story when it comes to equities. One of the key findings from a 2016 study by NN Investment Partners, in partnership with the European Center for Corporate Engagement (ECCE) at Maastricht University, is that a high ESG score is not necessarily a good indication of future corporate performance and that focusing on incremental changes or momentum can also enhance returns.

In addition, the research, which looked at over 3,000 companies operating in developed markets between 2010 and 2014, found that portfolios investing in firms with average ESG scores that were improving – i.e. had positive ESG momentum - had higher Sharpe ratios (a risk-return metric) than those that did little to improve their ESG score.

To summarise, the research shows that a company’s actions to improve its ESG score is likely to lead to greater risk-adjusted stock performance.

Advancements in corporate governance, in particular, can result in better investment parameters – i.e. a higher Sharpe ratio.

In addition, the study also found that another relatively simple way to improve the risk-weighted return rate of investment portfolios is to exclude controversial companies from the portfolio - i.e. companies that show poor, controversial behaviour in preceding years.

Company engagement is also a key theme in a 2015 study by Professor Elroy Dimson, chairman of the Centre for Endowment Asset Management, Dr Oğuzhan Karakaş, university senior lecturer in finance – both at Cambridge Judge Business School – and Dr Xi Li of the London School of Economics.

The trio examined 2,152 engagement discussions carried out by an anonymous asset manager with 613 US companies over a ten-year period. It turned out that the chance that a company will change its behaviour after the intervention of a shareholder amounts to 18%. The most effective are two or three interventions carried out between one and one-and-a-half years.

Statistically, during the year after the company implemented positive changes in terms of ESG, forced by shareholders, its shares grew by 7.1%.

The increase in quotations results from the fact that the companies listening to the shareholders begin to deal better in the operational dimension, achieve higher profitability, and if so – their share prices start to fluctuate less. The positive market response to successful engagement is most significant for corporate governance (+8.6%) and climate change (+10.3%). If the engagement does not bear fruit, the improvement in returns diminishes again.

Recipe for success
In an update last year, the researchers wrote that there is more chance of an engagement being successful if it is carried out by a large shareholder from the same region or if the party carrying out the engagement has significant assets under management.

The studies explored in this article are consistent with intuition – investment in companies that care for the environment, society and apply high standards of corporate governance, on average do better, which can lead to better risk-weighted returns in the long term.

There is no need for scientific research to sense that, for example, a company with a high G is less likely to be exposed to a corruption scandal involving management than a company whose corporate governance is failing.
The studies in this article clearly show how responsible investing can help improve risk/return of investment portfolios. These findings have been further supported by subsequent studies and underline the fact that making a positive impact can go hand-in-hand with attractive financial returns.

Jeroen Bos is head of specialised equity & responsible investing at NN Investment Partners

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