People, environment, trust – these are thought of as “soft” factors. But when measured systematically, these “soft” metrics actually can translate to “hard” results like future risk and expected return potential for intelligent investors.
Investing that integrates indicators of impact, sustainability and ESG (environmental, social, governance) performance has been discounted due to some socially responsible investment funds that lagged in financial returns, but also tended to have lower risk. Sophisticated investors use “alpha” and Sharpe ratios to connect risk and return in one financial calculation. In this feature, we present more evidence that future risk can be lower and returns could be higher when applying ESG analysis to your portfolio.
21st Century Investing – Including ESG Metrics
ESG Investing is based on the notion that future financial performance can be tied to quality of management and business models that solve human problems – or risk the possibility of a regulatory, public relations or investor backlash in the future that negatively effects business valuation. The use of these metrics can provide investors a potential advantage over the market as these factors are possibly not accounted for in the business’ valuation due to an exclusive focus on financial metrics in the efficient market hypothesis. ESG Investing has evolved as an investment tool in terms of the data available to guide portfolio allocations – using current, past or change in ESG performance to tilt the portfolio weights.
ESG investing is distinct from “Socially Responsible Investing” which constitutes an alignment of investors’ values with their investments’ ESG performance, such as the nature of the product (for example weapons, alcohol, gambling and tobacco are considered to be sin stocks) or the operations’ impact on climate change (especially fossil fuel stocks). The investment strategy in this case is using a negative screen to exclude investments that fall in a certain category or underperform their peers on certain ESG metrics.
Evidence Linking ESG and Financial Performance
A large majority of academic studies analyzing the link between superior ESG performance, cost of capital and financial performance have found that at the securities level, companies outperforming their peers on ESG metrics have a lower cost of capital and outperform their peers in both market-based and accounting-based financial performance.
A 2014 University of Oxford meta-study of 190 academic studies shows the positive impact of high ESG performance on cost of capital, operational performance of the firms and stock price performance. This positive relationship is a departure from commonly held notions about the loss of diversification and financial returns as a result of implementing negative screens. The use of these metrics as guide to financial performance has become increasingly important in a world where, for instance, 84% of balance sheet value of S&P 500 firms constitutes of intangible assets (Ocean Tomo, 2015).
Another way to look at the link between ESG performance and financial performance is from a firm’s perspective. “Integrated reporting” is a concept where companies provide both financial and non-financial information in the same reports, explaining the material impact of non-financial information such as energy efficiency, customer satisfaction, employee engagement and governance practices on their bottom-line and balance sheet. This practice not only encourages firms to monitor and report ESG metrics but understand the material impact of these metrics on their financial performance in an introspective manner. Examples of corporations regularly publishing integrated reports include Southwest Airlines Co (LUV) , Clorox Co (CLX) and Philips (PHG) .
In today’s global world, universal owners and institutional investors are actively invested in equity markets around the world. ESG performance has the potential to guide investors in their decision-making on international investment opportunities across asset classes. A Principles for Responsible Investing report presented research by several asset managers and research firms that found substantial links between sovereign bond returns and underlying ESG factors for the issuer countries. For these firms, ESG Investing strategy of weighting the portfolio based on ESG performance led to improved financial performance and improved identification of credit risk.
On the equity side, analysis of the investable equity market indexes of 38 countries around the world and the average HIP Ratings (measuring ESG performance) of the listed companies revealed a strong positive relationship between higher performance on HIP metrics and three-year and five-year total returns on those indexes.
An increase of 10 points in the average HIP Rating score translated to a +4.2% increase in historical 3-year returns and a +2.1% increase in five-year historical returns. The regression analysis controlled for average firm size, index size, country income levels, return volatility and exchange rate movements.
Intelligent Investing – The Way Forward
Interest in ESG investing continues to grow – worldwide, more than $10 trillion is invested in this way -- as investors discover the benefit of using ESG performance as part of their valuation models and investment decisions. As coverage, transparency, reporting and interest in ESG performance increases across stakeholders, these metrics will be streamlined within the current valuation models and financial analysis.
This can lead to a world where businesses are actively striving to improve their impact on the environment and societies that they operate in as well as an adoption of transparency and high standards of corporate governance as the new normal. A better portfolio comprised of better businesses, resulting in a better world. All investors, especially intelligent investors, can embrace that future world.
How do you invest for a better world in your for-profit portfolio? Share your commentary and suggestions in the comments section below. This is Part 4 in a four part series. Check out Part 1, Part 2, Part 3.
By Hummayun Javed and R. Paul Herman
Hummayun Javed is an impact investment analyst, with a Masters in Global Policy Studies from the LBJ School at the University of Texas at Austin; R. Paul Herman is CEO, CIO and an investment adviser representative (Series 65) of HIP Investor Inc. and CEO of investment ratings firm HIP Investor Ratings LLC (More info at http://www.HIPinvestor.com)
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