By Andreas Hoepner
A white paper recently published by the Deutsche Asset & Wealth Management Global Financial Institute, discusses how environmental social and governance (ESG) investing can enhance investment returns and reduce risk by integrating ESG data into investment decision-making.
The research illustrates portfolios of assets with high ESG ratings tend to outperform their benchmarks in various contexts. This is especially true when looking at recently popular ESG criteria such as corporate governance, eco-efficiency and employee relations. This outperformance has in cases even been sufficient to absorb hypothetical transaction costs of up to 50 basis points per trade. For instance the most sustainable firms globally, as announced during the World Economic Forum, have outperformed in two out of 10 industries as defined by the Global Industry Classification Standard (GICS) in the years after their public announcements. This is true despite the information being publicly available, which is a clear indication that financial markets are currently inefficient with respect to certain ESG criteria.
On the risk side, ESG datasets show strong risk management capabilities not only at the firm but also at the portfolio level. Firms with better ESG ratings experience higher credit ratings and lower cost of debt. Portfolios with better ESG ratings display substantially less downside risk of more than 200 basis points even if they have a substantially lower number of constituents. This implies that ESG ratings might even be useful to reduce risk in ETF-type investment strategies.
I believe that ESG information sets are commercially relevant for firms in many sectors but currently not included in many professional finance degrees. Hence, they have value but are currently often overlooked by the average analyst/investment manager. This makes them an attractive investment opportunity if, like me, you do not believe in Fama’s Efficient Market Hypothesis but instead in Grossmann and Stiglitz’s view that market efficiency is a cyclical process. According to this view, investors allocate resources to areas they believe to be inefficient and hence provide outperformance opportunities. If the area is fruitful, the first investors doing this will outperform but with an increasing number of investors entering the market, the opportunities decrease. Hence, the market becomes efficient and investors are not receiving decent returns.
This will drive the investors out of the respective area and, over time, lead to new opportunities that fewer and fewer investors are watching. In short, this view predicts that those investors who find profitable information sets which are barely known to their competitors perform best. I believe ESG datasets, especially the sophisticated ones, are such profitable information sets right now.
ESG investments, often also known as responsible investments, have grown nearly tenfold over the last decade, as financial markets have increasingly realised that integrating the ESG concerns of common people in investment decisions makes good business sense. The UN-backed Principles for Responsible Investment, launched in 2006, are signed by more than 1100 organisations with joint assets of more than $30trn.
The basic logic behind this growth is common sense in many proponents’ view. A company simply performs better when its employees are more motivated. Similarly, societal concerns about topics such as climate change or pollution have led to many business relevant government policies in the last decade. It is also common sense that better corporate governance, which provides managers with fewer means of advancing themselves over their investors, tends to be beneficial for shareholders.
Dr. Andreas Hoepner is from the Centre for Responsible Banking & Finance at the University of St. Andrews
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