Investing with a focus on environmental, social and governance (ESG) factors has been around since the 1960s, yet almost 60 years on, myths about ESG investment abound.
We are working our way through these myths. Last time, we looked at the claim that “there is no demand” for ESG – the numbers we gathered prove otherwise. Today, we’re tackling the arguably most persistent myth – that ESG investing negatively impacts performance.
There is of course a degree of truth here. The majority of ESG assets are in funds that employ ‘negative screening’ or ‘negative filters’ – a basic approach that essentially removes any stock or sector that is not deemed fit for an ESG-focused fund, like tobacco or alcohol. If the removed sector performs well, the ESG fund will inevitably lag behind.
Investors picking an ESG version of an index will have to accept that there will be a degree of tracking error from the parent index, and the performance will also differ – but it doesn’t have to be in a negative direction. Don’t forget that when comparing their performances, the time period and the index in question make a big difference. In other words, data can be skewed in any way the data provider wants to.
To prove that ESG indexes can and do outperform their non-ESG counterparts, let’s look at Blackrock Investment Institute’s Global Insights report from May 2018. The study, carried out between May 2012 and February 2018, found that the MSCI USA Index’s annual gross return in US dollars was 15.8% – the same result as the MSCI USA ESG Focus Index. The World ex-US index returned 10.5%, while its ESG counterpart beat this result by 0.6% over the same period. In emerging markets, the ESG index returned 9.1%, while its parent benchmark only produced 7.8%.
The ‘ESG Focus’ indexes used in this example – although they are only aimed to maximise ESG exposure within certain constraints – prove that not all portfolios with an ESG lens are going to hurt performance. However, we can’t ignore the examples also show that ESG Focus Indexes have fewer stocks, so are less diversified, and their volatility is marginally higher, except in emerging markets.
With negative screening, it’s easy to identify the ‘bad’ stocks or sectors. Now, how can we go one step beyond that? An MSCI blog in 2018 argued that rather than simply screen out the bad ESG stocks in a fund or portfolio, we need to rebuild the portfolio to make up for the exclusions – and benefit from the improved risk/return profile.
Because, in 2019, ESG doesn’t have to just mean excluding stocks. Rather, ESG-focused tools and research can be employed as an extra layer of insight and analysis to help improve the risk/return profile of the investment. A recent example of this is iShares’ ESG ratings across all of its ETFs – something we will explore in more detail in another post.
Performance comes down to several factors, including timing, market conditions, and so on – but investors know that one of the main determining factors of performance is fees. And even a few basis points can make a difference over the long term. Morningstar found that the average cost of an ETF in Europe is 0.33% per year, while the average ESG ETF was just 0.30%. That fact alone shows that we are heading in the right direction in terms of debunking the myth that ESG hurts your returns.
We have come along way since the 1960s. ESG can be used in all sorts of ways to improve performance, not hinder it. It can be a rich source of research and insight which is a bonus for any portfolio. Ultimately, ESG provides a new and evolved way to monitor, minimise and mitigate risk – which are all things that financial advisers and investors want more of in the current climate.