Practical analysis for investment professionals
01 September 2016

Does ESG Boost Returns?

Big questions usually come with incomplete answers.

Are you fulfilling your purpose? Is there life on other planets? Do you drink too much coffee? My own answer to the last one is a definite yes, but it would be hard to answer the other two with even a remotely similar degree of confidence.

Sometime between my parents’ generation and my own, the idea that a business could do both well (in a financial sense) and good (in a social sense) has entered the mainstream. Of course, at a general level, that is a bit like saying how great it is to get equity-like returns with bond-like risk: fluffy, sales-y, and skepticism inducing.

But it’s something people say because there is a large and growing body of evidence that it’s for real.

And if you think like a manager for a moment, it should be intuitive why this is. Start with employee engagement and retention: Doesn’t it stand to reason you’ll be better able to tap into the energy of your employees if they feel their work supports a cause they find meaningful? Isn’t it likely that would have at least some bearing on your ability to compete and, indeed, on whether you succeed?

Yes, But . . . 

That intuition is great for managers, but it’s hard for investors to translate into something actionable. We can audit the degree to which a company is “doing good” by examining the information it releases on environmental, social, and governance (ESG) issues, but the path from disclosure to value creation is a murky one.

One straightforward reason for this is that a lot of the information that exists is not intended for investors. And though there is convincing evidence that good performance on selected industry-specific materiality data leads to increased returns, translating those aggregate-level insights into portfolio-appropriate ideas is not a linear process.

With these issues in mind, it seemed natural to ask what readers of CFA Institute Financial NewsBrief thought of how examining these disclosures might yield better returns.


Do you think analyzing ESG factors can boost returns?*

Do you think analyzing ESG factors can boost returns?

* Results do not add up to 100% due to rounding.


Though only 7% of the 535 respondents said “of course” and suggested we Google it, the responses are quite consistent with my own belief that the investment profession sees at least the seed of alpha generation within ESG disclosures.

This is a question quite distinct from one we’ve asked much more rigorously in the recent past: Do you take ESG issues into account? Of CFA Institute members, 73% say they do, mostly because they view the analysis as a way to manage investment risks or because their clients demand it.

The plurality of respondents (37%) said something quite different: that these factors enter into any complete analysis.

CFA Institute agrees, and that’s why this year everyone who sits the Level I exam will find an added reading on ESG in addition to many others. It’s on the test because it matters: Imagine a company that fits your investment criteria but has a board packed with the CEO’s cousins. Or maybe revenue is growing much faster than costs, but the company releases no information about how it sources its materials.

Why would you ignore that?

I picked extreme examples for the sake of brevity, but they’re not impossible. And it’s hard enough to generate investment ideas, so it makes sense that nearly a quarter of respondents pay attention to this data by default. A further 16% of respondents gave the quite reasonable answer that their level of attention depends, since the information can be low quality or priced in.

This is true of information in general.

Another 15% of poll participants likely think that writing this up was a waste of time, that ESG material consists of nonfinancial information, which for such a cohort qualifies as non-important.

So I’d like to close by sharing some additional evidence that there is a link between strong performance on ESG factors and what investors care about by definition: generating cash from business activity.

Those studies say other things too, and are well worth a read. But those excerpts should give a good sense that there is at least the outline of an alpha opportunity to be had by looking at ESG data.

But translating that opportunity into performance is difficult. Just take it from someone who’s done it: David Blood, a founder of Generation Investment Management, notes that he is reluctant to talk about performance “In some respects because [he is] suspicious.” And it’s appropriate for you to hold that same suspicion.

It might be worth examining your suspicion more closely if this passage from a 2015 Morgan Stanley report on sustainable investing has no effect on it (emphasis theirs).

“We reviewed a range of studies on sustainable investment performance and examined performance data for 10,228 open-end mutual funds and 2,874 Separately Managed Accounts (SMAs) based in the United States and denominated in US dollars. In the scope of our review, we ultimately found that investing in sustainability has usually met, and often exceeded, the performance of comparable traditional investments. This is on both an absolute and a risk-adjusted basis, across asset classes and over time.

That’s not the end of the discussion, but it does move it along. To me, it means that there is room to consider a sustainable approach to investing alongside value investing or statistical arbitrage as a tool that a professional investor can use to generate alpha.

Whether you go out and do it is up to you. If you’d like to, CFA Institute has plenty of information to help.

This post summarizes and extends a 19 July 2016 talk that I gave at the United States Mission to the United Nations. We are grateful to Ambassador Sarah Mendelson and the US State Department for the opportunity.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

About the Author(s)
Will Ortel

Will Ortel has worked in investment management since 2006 and joined CFA Institute in 2010.

Ethics Statement

I try to see the world in its particularity and convey my curiosity clearly. I hope you think I do this in a fair and transparent way, and invite you to write me if you feel otherwise (or just want to say hello).

8 thoughts on “Does ESG Boost Returns?”

  1. Robert says:

    Will,

    Incredible job pulling all of these resources together on the current state of research and opinion on ESG integration! Not to mention the great job on your presentation to the United Nations.

    With increased attention on material ESG information, I’m convinced that businesses that understand how to capitalize on the data will improve their ability to generate cash flow and their investors will see better returns relative to the firm’s peers.

    1. Will Ortel says:

      Rob —

      Many thanks for the kind complement. And totally agreed! I think non-financial audiences are still stuck thinking the primary reason businesses should “do good” in addition to “well” is some reason other than enlightened self-interest.

      With time and data that perception will change — and it will be a very good thing. The investment community has the opportunity to be the lever that moves the world on good business practices. It’s inspiring that research in this area is not just pushing for, but cross-sectionally validating the importance of transparency, respectful treatment of stakeholders, and social integrity.

      Cheers, and hope to see you soon.

      Will

  2. Jeroen Bos, CFA, CAIA says:

    There is clearly some strong momentum in this field. At NN Investment Partners we also recently conducted a study, together with research institute ECCE, which showed that focussing on absolute ESG scores, from the likes of Sustainalytics, doesn’t contribute to outperformance but that actually looking at the momentum/change in these ESG scores does lead to better investment results. Futhermore, excluding controversial companies from your investment universe does add to performance, contrary to conventional belief. All in all some interesting outcomes and I am looking forward to more research in this field so we can continue to improve investment performance for clients !

    1. Will Ortel says:

      Jeroen —

      Many thanks for adding your perspective! That’s quite a sensible approach to take in examining ESG scores — great job digging further on it. Are you referring to a study on excluding controversial companies from your portfolio? Would love to check it out.

      Totally agreed these are some interesting and inspiring outcomes that amplify our ability to serve clients and humanity as a whole. Cheers, all the best, and thanks for your energy.

      Will

      1. Jeroen Bos, CFA, CAIA says:

        Hi Will, that is correct. We looked at both the impact of exclusions of controversial companies from the portfolio as well as the impact of ESG scores. Following the link below will lead you to the summary conclusions as well as the more detailed report at the bottom of that page !

        https://www.nnip.com/corporate/GB/en/Press/News-Commentary/view/Study-confirms-contribution-of-ESG-factors-to-investment-performance-says-NN-IP-1.htm

        1. Will Ortel says:

          Many thanks Jeroen — great stuff.

        2. Robert Mudra says:

          Jeroen, Thanks for sharing the link to your study. Go Orange!

          I thought this was an important finding about incremental rather than aggregate ESG scores, “Instead, the research demonstrated a clear positive relationship between incremental changes – or momentum – in a company’s ESG scores and investment performance. Stocks with positive momentum in ESG scores outperformed those with negative momentum, with the strongest positive performance effect found by companies with medium ESG scores.”

          Bob

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