The Wild West of ESG - Can making money and sustainability go hand in hand?

Last week we spoke about sustainable investing.

For some, this might be the only way they want to invest.

But it should still also net you some return, right? Otherwise, you might as well donate to charity instead.

For others, sustainable investing might be more of a “nice to have”, with having your money grow being the primary motivation.

So, in this newsletter, we look at the popular question: Can making money and sustainability go hand in?

Let’s compare ESG investing to non-ESG investing

Before answering this question, we first need to clarify what type of investing we will compare.

As we saw last week, there are many different types.

Today, we’ll compare ESG investing to non-ESG investing.

We’ll compare ESG investing because it is a bit more straightforward to compare.

This is a bit harder to compare to their “non-sustainable” counterparts.

Let’s answer our question by looking at the good, the bad and the ugly parts of ESG investing.

That sounds a bit like that old western...

Cue the music!

The Good: MSCI says ESG does well

MSCI stands for Morgan Stanley Capital International.

They are a large finance company based in the U.S.

They provide many different indexes, tools and ESG products. You might have heard of them before.

MSCI did a study on ESG and performance.

If I understand the study correctly, they didn’t check if ESG funds/portfolios actually outperform

What they did was look at companies with very high scores on ESG.

They conclude that ESG adds financial value in three different ways:

Higher profitability

• “High ESG-rated companies were more competitive and generated abnormal returns, often leading to higher profitability and dividend payments, especially when compared to low ESG-rated companies.”

Lower tail risk

• This means that high ESG-rated companies experienced fewer ‘major drawdowns**’ (big drops in share price) than low ESG-rated companies.

Lower Systematic risk

• High ESG-rated companies basically were a bit less volatile. That is, they were not as sensitive to the ups and downs of the market.

Sounds great, right? Green seems to do even better!

An important point to keep in mind, though:

• “correlation does not imply causation” ➡️ A positive correlation is excellent, but if we can’t explain why, how can we be sure it’s not a fluke?

• These benefits talk about the individual companies, not per se the performance of the overall fund or portfolio. Even though they are, of course, related.

The bad: HBR and researchers don’t seem convinced

It’s not all good news, either.

​This article in the Harvard Business Review speaks of a recent (2019) Journal of Finance paper.

In it, researchers of the University of Chicago analysed the Morningstar sustainability ratings of more than 20.000 mutual funds. The total value of those funds together was about $8 trillion.

The conclusion?

“Experimental evidence suggests that sustainability is viewed as positively predicting future performance, but we do not find evidence that high-sustainability funds outperform low-sustainability funds.”

Ouch.

The ugly: does ESG actually work?

You might think, “well, I don’t need to outperform. I’m happy to contribute to a greener planet and get the same returns as the rest of the market”.

The thing is that there’s more bad news in that same HBR article (dubbed “An Inconvenient Truth About ESG Investing”).

Another research, this time by the Columbia University and the London School of Economics, looked at the ESG record of companies.

They compared the U.S. companies in 147 ESG funds to those in 2.428 non-ESG portfolios.

Their conclusion? ESG Funds:

“… hold portfolio firms with worse track records for compliance with labor and environmental laws, relative to portfolio firms held by non-ESG funds managed by the same financial institutions in the same years.”

And lastly…

“Finally, ESG funds appear to underperform financially relative to other funds within the same asset manager and year, and to charge higher fees.”

What shall we make of all this?

To be honest, I was pretty shocked while doing this research and writing this newsletter.

I’ve seen ESG become increasingly important ever since I started working for the asset management industry.

I love the idea behind it, too. Connect your investment portfolio to your values. Don’t invest in companies that are behaving against your principles.

If ESG portfolios are a lot “greener”, it is okay if they underperform a bit.

Sustainability can have a price. But before we pay that price, we need to ensure we’re paying for true sustainability, not greenwashing.

While I applaud the ESG movement in its aims, it is clear there are “darker shades of green” when it comes to investing.

Another issue might be the lack of a clear definition for ESG investing. Your mileage may vary, that kind of thing.

What does the future hold for ESG?

I don’t think it’s game over for ESG. Quite the contrary.

Principles and standards are becoming more sophisticated, and so is the data on which companies are being judged.

So, as we move to an ever more transparent world, could ESG become a “minimum” standard?

A light-green baseline?

Only time will tell.

I would love to hear your thoughts on this newsletter and how YOU look at investing sustainably! You can always get in touch with me via [email protected]