Despite plenty of evidence to the contrary, an NEI Investments survey conducted earlier this year shows that most investors and their financial advisors still believe that responsible investments (RI) will underperform traditional investments.
In particular, the critics argue that considering the environmental, social and governance (ESG) performance of companies will reduce the size of the investment universe, reduce portfolio efficiency and generate lower risk-adjusted returns.
Although responsible investors agree that considering ESG factors will eliminate some companies from their investment universe, they argue that the remaining companies will be better long-term investments.
There have been many studies on the performance of RI relative to traditional investments. And the results have shown that they have achieved results similar to or slightly better than their non-RI counterparts.
In fact, there has been no penalty for investing according to your values. And the authors of the 2012 RBC Global Asset Management Inc. study entitled Does Socially Responsible Investing Hurt Investment Returns concur.
Among their considerations were the financial performance of RI indices relative to traditional indices; the performance of RI funds relative to traditional funds; and the correlation between socially responsible companies and improved financial performance. The chief finding in their research was that RI did not hurt investment returns.
Historically, ethical investing and socially responsible investing (SRI) have been based, at least in part, on values-based exclusionary screening. In the past two decades, the focus of many of those funds has evolved gradually. RI, defined as the integration of ESG factors into the selection and management of investments, has become widespread in both retail and institutional funds.
ESG criteria are used to help managers identify risks that are not adequately measured by traditional investment analysis. In doing so they are better able to accurately predict financial performance.
This doesn’t diminish a values-based or ethical approach, but enhances it by identifying the material risks and opportunities associated with ESG factors. It provides the information needed for investors to capture the financial benefits of ESG leadership.
In the 2012 report entitled Sustainable Investing, DB Climate Change Advisors looked at 100 academic studies, 56 research papers, two literature reviews and four meta studies on RI from around the world.
This analysis showed that the market consistently rewarded the companies with superior ESG performance with higher share prices. Those findings were supported by the studies DB Climate Change Advisors examined, as 85% of them showed a correlation between ESG performance and higher earnings per share.
If price performance and earnings per share aren’t enough, this report also found that companies with good ESG ratings have a lower cost of capital in terms of both debt and equity.
A lot of research has been done on the ESG risk inherent in stock picking and company analysis. That’s an important aspect of portfolio management; however, Allianz Global Investors took it one step further in its 2010 study entitled ESG Risk factors in a Portfolio Context.
The authors used a top-down model to analyze the link between ESG and the risk/return profile of a conservative balanced portfolio over a long-term time horizon. They concluded that over the next 20 years, ESG factors are expected to have a significant risk impact on equity investments and recommended that investors choose equity investments in companies that proactively mitigate these risk factors.
The results were significant. They found that the optimized portfolio gave an increase in expected return of 30 basis points at similar levels of expected portfolio risk. They found that the effect was even greater in riskier portfolios with higher equity weightings.
Almost every comparison of RI vs traditional investment returns points to better long-term risk-adjusted returns and positive societal impact. And in the Responsible Investment Association’s quarterly mutual fund reports (http://riacanada.ca/quarterly-reports/) there are top-performing RI mutual funds in every major category.
The evidence is in. You can reduce risk, enhance returns and according to recent surveys, earn the trust of your clients if you offer them RI. And if you don’t, someone else will.