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ESG and impact strategies – and their returns

After five years of positive flows into ESG-focused strategies in the public markets, it is unsurprising that sustainability-oriented investing (here, we use “ESG” and “sustainable” interchangeably) is coming under scrutiny. For example, the Jul 23, 2022 edition of The Economist ran a cover that said “ESG: Three letters that won’t save the planet.” Bloomberg, in June, reported on how ESG funds had fared less badly than the broader market in 2022 so far, despite owning relatively more technology names and relatively fewer energy stocks. Yet it also noted that over the last five years, Global, US and European ESG portfolios had each not kept up with their broader respective markets. (No extra information about how funds were categorized into either ESG or non-ESG groups was included, but Bloomberg did point out the finding was consistent across geographies.)

This conclusion is at odds with work that looks at performance over longer time periods. A 2015 paper noted that studies up to that point had generally only reviewed a fraction of the available literature, and sought to remedy this by extracting “all provided primary and secondary data of previous academic review studies.” And, the authors continue, “through doing this, the study combines the findings of about 2200 individual studies” which date back to 1982. This work found that overall, about 9% of the prior papers found a negative relationship between ESG and what they label corporate financial performance, or “CFP.” 63% of the studies found a positive relationship, and the balance could find no relationship at all. Of note, this conclusion is stable over time, across different geographies, and across asset classes. Some studies looked at E, S, and G separately, and some together, some focused on equities, or fixed income, or real estate, or were portfolio-wide.

Another paper, from about the same time, looks at the question of sustainability and financial performance from a different angle. Eccles and his co-authors created 90 matched pairs of firms, where one of the pair was labeled “high sustainability” and the other “low sustainability”, but in most other respects – such as industry, size, capital structure and growth opportunities – were very similar. Companies were placed in one category based on whether they had adopted a “substantial number of policies…for a significant number of years (since the early to mid-1990s), reflecting strategic choices that are independent and in fact, far preceded the current hype around sustainability issues.” As one would expect, “high sustainability” companies are more likely to create a dedicated committee at the board level to supervise sustainability-related questions, and to tie the pay of company leadership to customer satisfaction, social and environmental performance. Most notably, the “high sustainability” group outperformed their peers over the 1993 to 2009 time span, “both in terms of stock market and accounting performance” – such as return on equity and return on assets. Furthermore, this difference is more marked among companies that sell based on reputation/brand, “business-to-consumer” companies, and those that make “substantial use of natural resources.”

Given how quickly the space has been evolving, it is worth looking at more recent research, even if it examines shorter time frames. A paper from mid-2022 does just that, and focused its analysis on papers that were published since the 2015 meta-analysis referenced above. It found roughly the same number of unique studies as did the 2015 paper, which looked back over 30-plus years. The main conclusions from this work are twofold. First, there is a good evidence to connect ESG with superior corporate financial performance at the level of an individual operating company. This is consistent with the findings of Eccles et al. Second, the study found that “the financial performance of ESG investments is indistinguishable from conventional investments.” As the authors note, this inconsistency is puzzling. Various possible explanations exist, and each is supported by some evidence. These include:

  1. “ESG investing” is too broad a concept to be useful here. It blends strategies that are ethics-driven, and not returns-maximizing, with those ESG strategies that do seek to maximize-returns.
  2. ESG investors can’t implement their strategies effectively because they don’t have access to good sustainability performance data. (The inconsistency of ESG disclosure and data aggregation approaches is well documented.)
  3. The superior corporate financial performance associated with high sustainability companies may quickly be priced in, making it hard to distinguish between the returns of an “ESG portfolio” and a “non-ESG” portfolio over certain time periods.

Based on all this, what conclusions can investors draw? A key principle is understanding the nuances. It is generally preferable to seek portfolios that integrate ESG factors in investment decisions rather than apply inflexible screening rules – and that this integration should rest where possible on the traditional tools of alpha-seeking active portfolio management, whether in the public or private markets. These techniques include engagement with company leadership as well as selectively with the rank and file, comprehension of key industry-wide trends, and the identification of catalysts that can unlock near-term value. For as long as ESG disclosures and ratings systems are hard to trust, these tools may be particularly valuable.

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