Can investors improve returns by reducing ESG risks?

By LARRY SWEDROE

The increased popularity of ESG investing has been accompanied by a rise in research into the subject. The heightened investor interest in sustainability has also led to changes in cash flows — raising the cost of capital of companies with poor ESG scores and lowering it for companies with good ESG scores. That, in turn, has led to changes in corporate behaviour as corporations seek lower costs of capital or face being disadvantaged. In addition, companies are seeking to reduce the risks of negative events that lead to heightened risks of lawsuits (for example, over environmental incidents and discrimination) and consumer boycotts. Companies have also recognised that “doing good” not only improves their reputation but leads to attracting employees who desire to work for companies acting responsibly, enhancing employee satisfaction and, in turn, employee productivity. Those behaviours are leading to positive feedback loops. So can investors improve returns by reducing ESG risks?

New research

William Martin, Aleksandar Pramov and Dimitri Huwyler, authors of the March 2022 study Seeking Financial Performance by Avoiding ESG Risks: Sustainable Investing in the World of Equities, investigated the integration of environmental, social and governance (ESG) scores constructed from company misconduct and incident data into the systematic investment process for equities and evaluated their performance in U.S. and European markets. They began by noting that today there are mainly five ESG strategies among asset managers: exclusionary screening, best-in-class screening, norms-based screening, integration and sustainability-themed investing. The largest sustainable investment strategy globally (and in Europe specifically) is negative/exclusionary screening, followed by ESG integration. In the U.S., the leading strategy is ESG integration. Their paper adopted “the best-in-class/exclusionary screening and sustainability-themed investing strategies [such as climate change, greenhouse gas emissions and global pollution, which they referred to as GHG] respectively consisting in including/excluding companies based on specific ESG criteria and investing within a theme of sustainability.”

Their ESG incident data was provided by RepRisk, a data science company based in Zurich, Switzerland. Their process combines machine learning and human intelligence to identify ESG risks from public information, characterises them in a quantitative way, and stores them in a historical database. As of January 2022, RepRisk’s due diligence database covers more than 190,000 companies and 50,000 infrastructure projects worldwide across all sectors and industries. Their data goes back to January 2007. An incident is characterised by:

Severity [1, 2, 3]. The severity of an incident is determined by taking into account three aspects of the incident: the nature of its consequences (e.g., related to the health of employees or ecological damage), the extent of its impact (e.g., an individual versus a group of individuals) and the nature of its cause (by accident or intentional).
Reach [1, 2, 3]. The reach of an incident is determined by the scale at which the news is circulated geographically and by importance in a specific country. For example, an incident featured as the main story in a newspaper read worldwide will have the highest reach.
Novelty [1, 2]. The novelty of an incident is determined by the incident rate of the underlying company or project. A novel incident will have a higher novelty level.

Martin, Pramov and Huwyler translated the incident data into an ESG score that was quantifiable and comparable, and analyzed performance over the period January 2010-November 2021 for the S&P 500 and STOXX Europe 600, sorting stocks into quintiles. Following is a summary of their key findings:

Across countries, the U.S. and Italy had the worst ESG scores in the last decade, while Poland and Luxembourg scored the best.
ESG scores, reflecting how companies are facing ESG-related risk, were a key factor in distinguishing financial performance.
ESG scores were negatively correlated (-0.46) to value (possibly because sustainable companies tend to have lower costs of capital/higher valuations), positively correlated (0.35) to momentum (which could be explained by the strong increase in fund flows to sustainable investing strategies), and uncorrelated to market beta and size.
While exhibiting lower volatility, on a risk-adjusted basis (adjusting for exposure to common factors used in asset pricing models such as value and momentum), portfolios consisting of top ESG scorers consistently outperformed the benchmark, whereas portfolios built from selecting bottom ESG scorers consistently underperformed it across all investigated universes.
Top ESG scorers yielded an improvement of 10.7 percent to 22.0 percent in Sharpe ratio relative to the benchmark across universes, mainly fuelled by higher returns.
Investing with an ESG lens can bring an over/underexposure to particular sectors—an undesirable feature from a risk management perspective, which can be mitigated by taking a best-in-class approach that neutralises for sectors.
A GHG-themed strategy, constructed by removing all stocks involved in at least one GHG incident, led to an improvement of 193 and 139 basis points in annualized return and 17 percent and 26 percent in Sharpe ratio with respect to the benchmark for the S&P 500 and STOXX Europe 600, respectively.

Words of caution

Before you draw any firm conclusions, a caution is warranted. Conflicting forces can create problems in interpreting research findings because investor preferences lead to different short- and long-term impacts on asset prices and returns. The tremendous increase in cash flows to sustainable strategies that only began to gather steam over the last decade led to firms with high sustainable investing scores earning rising portfolio weights, leading to short-term capital gains for their stocks — realised returns rose. However, the long-term effect is that higher valuations reduce expected long-term returns. The result can be an increase in “green” asset returns even though “brown” assets earn higher expected returns. For example, the authors of the study Dynamic ESG Equilibrium found that despite investor preferences for sustainable investments creating a brown premium of about 1 percent per year, over the period 2018-2020 the increased demand for sustainable investments led to a green portfolio outperforming by about 7 percentage points a year (14 percent versus 7 percent)!

Perhaps with the problem of conflicting forces in mind, Martin, Pramov and Huwyler did note: “The best ESG quantile has in many cases only started to clearly outperform the benchmark around the middle of the decade” — just as the tide of increased investor flows began to surge.

Investor takeaways

As my co-author Sam Adams and I explained in our book Your Essential Guide to Sustainable Investing, both economic theory and the evidence from studies such as “Dynamic ESG Equilibrium” make clear that while sustainable investment strategies do reduce exposure to risk (companies with higher ESG scores have better risk controls and suffer fewer ESG incidents, fewer frauds, fewer consumer boycotts, etc.), once a new equilibrium is reached in terms of cash flows, ESG strategies should have lower expected returns due to their higher valuations (caused by both investor preferences and risk). However, we also noted that investors can have their cake and eat it too by tilting their ESG strategies to factors that have demonstrated premiums (such as size, value, profitability/quality and momentum) and specifically toward companies with positive ESG momentum (rising ESG scores). And finally, as we also noted, since we may be in the early to middle innings (no one knows with any certainty) of the transition to a new equilibrium (ESG strategies are now estimated to account for 40 to 50 percent of investments), at least in the short term it is certainly possible that while green assets have lower ex-ante expected returns, they can outperform (as they did from 2018-2020) — a perfect outcome for sustainable investors.

For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, but its accuracy and completeness cannot be guaranteed. Mentions of specific securities should not be construed as a recommendation. Individuals should speak with their qualified financial professional based on his or her own circumstances. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements, or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability, or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products, or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Wealth® or Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. Buckingham Wealth Partners is not affiliated with the above-mentioned fund companies. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the adequacy of this article. LSR-22-306.

LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.

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