Environmental, Social and Governance (ESG) is a responsible investment strategy that seeks both financial return and positive change.
The three pillars of ESG investing combine to define what most people would categorise as good business practice. Environmental issues cover how companies interact with the environment, Social issues cover companies’ conduct towards their internal and external communities, and Governance issues cover how companies behave in their business activities.
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ESG investing can take several forms and, broadly speaking, these can be categorised into how diversified the resulting investment is:
The most concentrated approach, this style usually takes the form of being goal-driven, for example investments in social housing projects to alleviate homelessness.
Here the approach is to identify companies that exceed a pre-determined level in one or more of the ESG categories. Companies that pass the screening criteria are eligible for investment.
As the name implies, this approach screens a universe of potential investments and seeks to exclude those companies that fail to reach certain minimum criteria in their ESG measurements.
The most diversified approach, this method seeks to integrate ESG concerns into a predefined investment strategy. There may be some companies that fail to qualify, but the aim is to preserve the risk and return characteristics of the investment while taking ESG issues into account.
ESG Investing and Performance
Studies show that applying ESG criteria does not harm performance and may improve investor returns.
Over the past decades, there have been more than 2,000 empirical studies and several review studies on the relation between ESG criteria and financial performance. Many recent studies document outperformance of such funds (Kempf and Osthoff 2007; Derwall, Koedijk, and Ter Horst 2011), or at least that funds “do equally well or badly while doing good.” (Brière, Peillex and Ureche-Rangau, 2017).
The findings of these studies contradict the common perception of many investors that screening out controversial securities and implementing ESG policies reduces performance. There is a positive relation between ESG and corporate financial performance (Bassen, Busch and Friede, 2015).
A recent simulation study by MSCI (Giese & Nagy, 2018), using hypothetical long-short portfolios, looks at companies with improving ESG momentum scores (defined as year-on-year changes of MSCI Industry-adjusted ESG scores, which are a proxy for the a change in the ESG profile of companies). The simulation finds that, over five years, companies with positive ESG momentum outperformed companies with negative ESG momentum by 14.4% in emerging markets, and 5.2% in developed markets.
The below chart compares a range of Morningstar Indexes to their ESG counterparts since their common inception (minimum three years to 31/10/2019). You can see that the ESG version of the index has outperformed in each asset class.
The below table is a comparison of traditional equity benchmarks and back tested ESG-focused counterparts by region, 2012–2018.