Debunking the biggest myth about responsible investing | Fin24

Debunking the biggest myth about responsible investing

Oct 30 2018 14:26
Jon Duncan
Jon Duncan

Jon Duncan is head of the responsible investment programme, and of the sustainability research and engagement function at Old Mutual.(Picture: Supplied)

Responsible investing is rooted in an understanding that how we invest today determines the quality of our future. 

Simply put, if we continue to invest in unsustainable companies that erode public trust, pollute the environment, and drive inequality, we should accept bestowing a world onto our children that is worse off due to our inaction.

A core myth associated with responsible investment, however, is that companies that focus on environmental, social and governance (ESG) issues reduce returns on capital and long-run shareholder value. 

The reality – as evidenced by both academic and industry research – is the contrary. 

In fact, companies committed to ESG practices show specific measurable characteristics, such as lower cost of capital, better resource efficiency, stronger innovation, lower staff turnover, stronger social licence to operate and better access to markets – all attributes that can, and do, influence competitive advantage and long-term performance. 

Because of the emergence of ESG data series that now spans, in some cases, as long as 10 years, it is now possible to test the implication of ESG on portfolio performance. 

As such, during 2017, we compared the returns of the MSCI Emerging Markets Index constituents, grouped according to their ESG ratings for the period 31 January 2013 to 31 May 2017. 

Companies were ranked and placed into five portfolios according to their ESG score, with the highest-scoring companies placed in Portfolio 1, and the lowest-scoring companies placed in Portfolio 5. 

These portfolios were also equally weighted at the start of the analysis, without rebalancing, to allow for price movement in order to see how each portfolio would perform if we held on to the same basket of companies for the duration of the investment period. 

The results are depicted in the graphs: Portfolio 1 – with the highest ESG scores, with 18.8% – and Portfolio 2 with the second-highest ESG scores, with 19.3% – outperformed the information technology (infotech) sector by 23% and 23.5% respectively.

Graph 1
Graph 2
Graph 3

These quantitative research findings provide compelling support for the general ESG outperformance hypothesis. 

We were, however, concerned that it might have been a “good time” signal that would only add value in bull markets. 

To test whether ESG factors provide alpha in both bull and bear market conditions, we decided to test two extreme sectoral performances over the same period.

During the period under assessment, the infotech sector showed significant outperformance, whereas the energy sector underperformed. 

The same methodology was applied to both sectors for the same period, and even though the infotech sector as a whole performed well at 53.6%, the companies in Portfolio 1 significantly outperformed their lower ESG scoring peers in Portfolios 2 to 5. 

Portfolio 1, with 84.5%, outperformed the infotech sector by 30.9%.

The energy sector, as mentioned above, experienced a negative return of 19.1% during the assessment period.

However, we can see from Graph 3 that even in bear market conditions the better-rated ESG companies continued to show positive performance. 

Portfolio 2 significantly outperformed Portfolios 3 to 5, as well as the energy sector as a whole by 32.2%.

The findings of our research corroborates a study titled Can ESG add Alpha by Zoltán Nagy, Altaf Kassam and Linda-Eling Lee, which was published in the 2016 Journal of Investing. 

This particular piece of research showed how ESG data could be leveraged using two different strategies, either by tilting portfolios towards high-performing ESG companies or companies with good ESG momentum over time. 

We have further leveraged MSCI ESG data in our development of an ESG best-in-class index for the local markets.

The above chart illustrates the performance of this index in relation to the JSE shareholder-weighted index. 

Though we cannot guarantee future outperformance, the trend supports the fact that the ESG-led index has paid off relative to the market index. 

Jon Duncan is head of the responsible investment programme, and of the sustainability research and engagement function at Old Mutual. 

This article originally appeared in the 25 October edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

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