Conventional wisdom holds that taking “non-financial” factors into account when making investment decisions will cause an investment fund to underperform. Non-financial factors include environment, human rights, labor, gender equity, etc.
Conventional wisdom is wrong.
Wrong, at least, according to a newly released meta study published in the Journal of Sustainable Finance & Investment. The study, “ESG and financial performance: aggregated evidence from more than 2000 empirical studies” concludes that “roughly 90% of studies find a nonnegative ESG-[corporate financial performance] relation [and] . . . the large majority of studies report positive findings.”
So how can it be that conventional wisdom is so different than the research?
First, there is an assumption that ESG investing focuses on excluding companies from a portfolio. Conventional wisdom will often complain that this “limits” the companies available to the portfolio and therefore hampers returns. While it may limit options, actively managed funds (most funds) eliminate most of the options available to them, so having a slightly smaller set of options doesn’t have to be devastating to portfolio construction. (For a deep discussion of this concept, see “Measuring the Risk Impact of Social Screening” by Patrick Geddes at Aperio Group. Full disclosure, I also work at Aperio.)
Second, in the real investment world, some funds do well and some funds do poorly. This is true for ESG funds just as it’s true for “mainstream” funds. You can no more say all ESG funds will perform the same than you can say all mainstream funds will. USSIF, the industry group for ESG investors, publishes mutual fund performance data for SRI funds. As you’ll see from its chart, there is a wide range of performance, both above and below the S&P 500 return for 2015.
Third, it makes sense that what we think about as ESG issues can easily trip up companies and do significant harm to their value. Not all ESG issues, not all the time, but there are plenty of examples of companies that have a significant blemish that falls squarely inside the ESG sphere. Volkswagen, BP, and Exxon are easy examples. The oft cited concept of “years to build a reputation, seconds to destroy it” is the plain English version of ESG risk.
Finally, note that the myth I’m debunking is that ESG equals underperformance. There is a big leap from debunking this myth to predicting alpha. Guaranteeing outperformance is not the opposite of guaranteed underperformance. The opposite is no guaranty. Each ESG fund needs to prove its worth just as each mainstream fund must. ESG funds should be held to the same standard, but not required to meet a higher one.