Investing in good conscience
As early as the 1970s, some investors have tried to emphasize moral values in their decision making through socially responsible investments (SRI). Stocks or securities that were linked to companies perceived as morally irresponsible were actively avoided in this philosophy. For example, tobacco producers or gambling providers were often blacklisted. Opponents of SRIs said that diminishing your investment universe will result in a sub-optimal portfolio because of a self-imposed lack of diversification. However, in more recent years, the concept has involved into the practice of ESG investing, which has gained a growing amount of attention in the investment management sector. Now, the idea is to take environmental, social and governance factors into account when making investment decisions. The argument that this would result in underperforming portfolios is still plausible, were it not for the growing amount of evidence to the contrary. There seem to be reasons to assume that advertising yourself as a responsible market participant may not be the only argument in favor of implementing this strategy. This article will discuss some of the reasons why taking ESG factors into account may prove to be economically sound, and look at the performance of these strategies.
It is interesting to see how the idea of investing in a responsible way has gained a growing amount of attention over the past decades. In a paper of Friede et al. (2015), summarizing the results of more than 2000 empirical studies on the topic, we can see that over the 25 years from 1970 to 1995, there were less than 500 studies conducted on the relationship between ESG criteria and the financial performance of a company. However, during the 20 years leading up to 2015, this number more than tripled to over 1500. As the prominence of ESG increases in the workplace, the academic interest in the topic seems to grow exponentially. This increased prominence in the workplace can be shown by the steep rise in assets invested in socially responsible mutual funds and ETFs. The graph below presents these numbers for the U.S. market, where we can see that the amount of socially responsible invested assets has doubled over the last decade. As of 2016, more than 20% of assets under professional management are invested in a sustainable and responsible way. Not only the total amount invested, but also the number of funds being offered to investors has undergone a sharp increase over recent decades. The report on US Sustainable, Responsible and Impact Investing Trends 2016 from the US SIF, the forum for sustainable and responsible investment, mentions only 55 ESG funds in 1995 and sees this number rising to 201 and 1002 in 2005 and 2016, respectively. Again, we see the same exponential growth.
What is the cause for this growing popularity? There are a number of ways in which companies that pay attention to environmental, social or governance factors are said to outperform their peers. The environmental issues that are present in the world today put a lot of pressure on governments to tighten regulation concerning topics such as pollution and the preservation of nature. Some regulations are already implemented today, but this is expected to increase as the effects of our impact on the environment grow stronger. So companies that already diminish their negative impact on the environment today have the possibility to do this in an efficient and economically sustainable way, while companies that are only planning to adapt when these future rules come into effect will have to change their practices much more quickly and thus presumably more inefficiently. It is also clear that good corporate governance standards contribute to the long-term performance of companies. A lack of good governance codes may lead to management taking decisions to pursue their own short-term benefits and exposing the company to potential legal and reputational costs. A historical example in support of this is the Enron agency problem, where the internal control structure was not strong enough to prevent the company from falling into bankruptcy. As for the social factor, although creating a good company image plays a role in all three factors, this reason is especially present here. Companies who are engaged in contributing to good causes within the communities in which they operate will definitely be perceived more positively and become a more preferred choice for consumers, increasing their revenues. Clearly, there are a number of reasons to assume that companies will be able to increase their operational performance when paying attention to ESG factors.
The data on the performance of funds taking ESG factors into account indeed seem to support the above reasoning. A report from the Morgan Stanley institute for sustainable investing from 2015 mentions that “sustainable equity mutual funds had equal or higher median returns and equal or lower volatility than traditional funds for 64% of the periods examined.” A quick look at the graph below shows that the S&P 500 ESG Index has clearly performed better than the regular S&P 500 Index over the past 8 years. This outperformance may be due to the fact that there are more assets allocated to these funds, driving up the price as a consequence of increased demand. This increased demand could just be a result of the fact that investors become more ethically inspired and does not necessarily need to reflect a fundamental outperformance that is sustainable in the long-run. The paper of Friede et al. mentioned above, however, points out that about 90% of the studies in their sample find a relationship between ESG criteria and financial performance that is nonnegative. Moreover, they find that a large majority of studies discover a positive relationship between these variables. This evidence indicates that the stronger financial performance of ESG, instead of only its ethical aspect, causes a growth in attraction from investors. So the rise in ESG investing is based on sound fundamental research indicating that it is also the economically right thing to do.
Altogether, it seems that the trend towards ESG investing is a nice example of Adam Smith’s invisible hand in action. Investors are recognizing that companies who take environmental, social and governance factors into account in their decision-making are also more likely to perform well financially. As a consequence, capital will flow towards the more ethically acceptable projects in our society out of pure economic self-interest. Of course, this does not mean that strictly moral motives do not play a part at all, but at least there does not seem to be a fundamental conflict of interest between your conscience and your wallet over the long run.
Sources: US SIF, Forbes, Morningstar, Morgan Stanley Institute For Sustainable Investing, Oxford Business Law Blog, Bloomberg
Source recommended for further reading:
Gunnar Friede, Timo Busch & Alexander Bassen (2015) ESG and financial performance: aggregated evidence from more than 2000 empirical studies, Journal of Sustainable Finance & Investment, 5:4, 210-233, DOI: 10.1080/20430795.2015.1118917
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