A key question surrounding ESG investing has long been whether investors must be willing to accept a risk/return trade-off to invest in companies with strong ESG practices.
Morningstar researchers set out to try to answer this question using a new model to compare the returns of companies with strong and weak ESG practices. In their resulting report, “Better Minus Worse: Evaluating ESG Effects on Risk and Return,” they conclude that investors apparently can build a global portfolio of companies that have positive ESG attributes without compromising returns.
If investors restrict their holdings to only U.S. and Canadian securities, they would have slightly underperformed for holding better ESG securities, the study explains. The research also sees no evidence that ESG holdings reduce or increase the risk of both a global and U.S./Canadian portfolio.
Study authors Patrick Wang and Madison Sargis explain that as the market recognizes the value of companies’ ESG practices, a premium might exist in return that induces investors to hold companies with poor ESG practices to compensate for any ESG-related risks, such as environmental disasters or corporate scandals due to governance failures.
“Although this makes economic sense on the surface, our study found no risk/reward trade-off to investing in ESG on a global level and only a slight cost if we limited the universe to U.S. and Canadian holdings,” Wang and Sturgis note. They also found that ESG appears to be a “distinct investment factor,” meaning that it is either moderately or not correlated to other known factors.
Hypotheticals
The authors note that when they compared the attributes of three hypothetical global portfolios (Better, Medium and Worse ESG ratings), they found that companies with Better ESG ratings tended to be larger in market capitalization and more mature with higher earnings and dividend yield. For average monthly returns, the findings show that there were no economically significant differences between each ESG group.
Wang and Sargis observe, however, that the U.S. and Canada ESG portfolios exhibited similar characteristics to the global portfolios, but they also saw an inverse relationship between ESG score and monthly return. The Better ESG portfolio had a monthly return of 0.89%, compared with 1.06% from the Worse ESG portfolio. “This is the first indication that investors owning high-scoring U.S. and Canadian securities may pay a penalty,” the researchers note.
From a cumulative return perspective, they found that the three global ESG portfolios closely tracked each other over the sample period, with no substantial differences across their returns. However, in the U.S. and Canada, they again saw evidence that there may be a premium for tilting toward ESG companies. The report shows that the Worse ESG portfolio earned 212% return over the sample period, while the Medium and Better portfolios earned only 198% and 157%, respectively.
“Across multiple tests, we’ve found that investors can build global portfolios tilted toward high-scoring ESG companies without compromising return. However, investors building portfolios in the U.S. and Canada face a small return discount for investing in these ESG companies,” Wang and Sargis write.
DC Plan Hesitancy?
So, what’s holding back ESG options in DC plans, even though more than 60% of DC participants—including 76% of Millennials—look favorably on investments that align with their social views? A recent blog post by BlackRock tackles the possibilities.
Addressing the argument that “It’s just a feel-good approach to investing,” the post contends that’s not what sustainable investing is about, explaining that it’s about a “growing body of research” that connects ESG-related issues to financial risk and investment opportunity.
For instance, the post points to BlackRock Chairman/CEO Larry Fink’s annual letter to CEOs, which observes that climate change poses several types of investment risk and that it is just one example of “sustainability-related concerns that have introduced unpredictability for investment managers.”
The post also takes on the alleged myth that the “DOL has put up too many hurdles.” While the DOL guidance has stated that sustainably cannot be the primary consideration when choosing investment options, it can be used as a “tiebreaker,” BlackRock notes. What’s more, the post observes that that hurdle may have “become easier to clear as advanced data, more efficient implementations and increased scale have improved results.”In fact, the data shows that ESG Indexes have performed at parity, or in some cases more strongly, than the parent indexes.
Finally, in addressing a “myth” that sustainable options are limited to specialty strategies, the post again cites Fink’s letter, suggesting that sustainability should be a “new standard” for investing. “If, as we believe, sustainability is increasingly important for identifying critical risks and return opportunities, it would be poor fiduciary practice on our part to limit sustainable implementations to specialized options,” the post states.
