Is sustainable investing a fad? Everyone seems to be talking about it — not least product providers eager to persuade us that their sustainable funds are so much better, more ethical or more likely to outperform than everyone else’s.
Leaving aside the moral reasons for investing in funds that aim to deliver environmental and societal benefits, is sustainable investing a good idea financially? Do sustainable funds, otherwise known as ESG (environmental, social and governance) funds, deliver higher investment returns than their mainstream counterparts? What does the evidence tell us?
The first question to ask is this: Is there any reason why high-sustainability companies should produce higher returns than low-sustainability firms?
The link between ESG and financial performance
A study published in 2014 analysed data from 190 of the largest US companies between 1993 and 2010. It found that high-sustainability firms tended to have a higher degree of long-term planning. They also measured non-financial criteria to a greater extent than their low-sustainability peers. The researchers also concluded that high-sustainability companies “significantly outperform their counterparts over the long-term, both in terms of stock market as well as accounting performance”.
The authors of a German study published in 2015 reached a similar conclusion. Aggregating information from more than 2000 studies, they found that “the business case for ESG investing is empirically very well founded”. They also showed how the positive correlation of high ESG scores and corporate financial performance appears stable over time, and manifests itself across different sectors and regions.
So far, then, the evidence is encouraging. High-sustainability companies tend to perform better and so, in theory, those who invest in them can expect to receive higher financial returns.
Do sin stocks outperform as well?
There is, however, another side to the story. In a study published in 2009, Harrison Hong and Marcin Kacperczyk made a strong case for doing the exact opposite and investing instead in so-called sin stocks. There was, they suggested a “societal norm” against, for example, betting companies and producers of alcoholic drinks and tobacco. As a result, they showed, such stocks are less likely to appeal to norm-constrained institutions such as pension funds, and their prices are relatively depressed. Lower prices, of courses, mean higher expected returns.
According to the highly respected investment author Larry Swedroe, investors are better off investing in the whole market — including sin stocks — using low-cost index funds. He recently looked at three popular ESG indexes managed by MSCI. In each case he showed how the ESG index had underperformed its mainstream equivalent since its inception. What’s more, each of the mainstream indexes had a higher Sharpe Ratio; in other words, they also took slightly less risk.
Different indexes, different results
But index providers use different selection criteria, and what’s true for one provider isn’t necessarily true for another. Last month, for instance, Ben Leale-Green from S&P Dow Jones Indices compared the performance of the S&P 500 Index of US stocks with its ESG equivalent.
While the S&P 500 ESG Index does exclude some sin stocks, it takes a more holistic view of sustainability and removes the companies with lowest ESG scores. For the period from May 2010 to the end of July this year, the excess return over the risk-free rate for the S&P 500 ESG Index was very slightly higher than it was for the S&P 500. The annualised volatility of the S&P 500 ESG Index was also slightly lower.
Another major financial institution that advocates sustainable investing is Morningstar, Three years ago it produced research which concluded that “the idea that ESG investing is a recipe for underperformance is a myth”.
Of course investors should be more sceptical about data provided by companies than by independent academics. We should also remember that sustainable investing is still relatively new, and that we don’t have anything like as much historical data to work on as we do with mainstream investing.
That said, the evidence so far does seem to suggest that, if there is a performance penalty for ESG investing, then it’s only a very small one. You might, over the long term, receive a modest performance premium.
As always, the most important thing to focus on when choosing a sustainable fund is the cost. Simply put, the less you pay, the more you keep for yourself.
Remember too that you don’t have to use active funds. There are plenty of sustainable funds that are broadly passively managed. Active management is a zero-sum game before costs, and a negative-sum-game after costs. The average sustainable investor using active funds must underperform the average investor using passive funds. It’s simple arithmetic.
A version of this article was originally published in MoneyWeek.