27 Sep 2019

Does ESG mean choosing principles over performance? 


Welcome to the third and final instalment in our three-part series on ESG investing. 

In week one we looked at three of the main drivers that support ESG in portfolios: how recent financial crises, growing climate change awareness, and increased regulatory pressure are combining to create a new investing landscape.

In week two we looked in more detail at demand for ESG products and analysed how flows have been split between active and passive funds, as well as highlighting the rise of ESG ETFs.

This week we look closely at the most common concern relating to ESG investing: does it require a compromise on performance? 

The #1 question for ESG investors 

Does investing sustainably mean giving up on potential returns?

To answer this question, the Lyxor Dauphine Research Academy sponsored researchers from the University of Lausanne to examine the link between ESG investing and broader investment performance. Their results are published in a new paper, called ‘ESG Investing: From Sin Stocks to Smart Beta’.1​

The research asked and answered three key questions: 

  • Does an investment in ESG degrade a portfolio’s performance?
  • What kinds of biases does a positive ESG screening strategy introduce?
  • Are there some factors that work better than others? 

Step 1: Define stock universe and ESG scoring approach 

The researchers - Fabio Alessandrini and Eric Jondeau - analysed a broad set of risk and return characteristics for up to 7,000 global stocks from the MSCI All Country World Index over the period from January 2007 to December 2018.

Each firm was awarded a score from 0-10 in each of the cornerstones of ESG – environmental, social and governance policies – as well as a composite ESG score. 

Step 2: Analyse the effect of excluding stocks according to ESG scores 

Next they analysed the impact of using this ESG score to progressively exclude stocks from the starting universe.

Their first finding was that progressively excluding the worst ESG performers led to an improvement in the average ESG score of the remaining portfolio constituents.However, the risk-return characteristics showed neither an improvement nor a deterioration.

Impact of ESG screening on MSCI Europe index


Second, the researchers looked at the effect of screening portfolio constituents according to their environmental, social or governance scores and arrived at a broadly similar conclusion: the improvement observed in the ESG profile of portfolios does not seem to happen at the expense of risk-adjusted performance.

The same outcome was observed when applying an ESG filter to smart beta portfolios. Their observations showed that, in most cases, ESG filtering results in an improvement in portfolio performance, even on a risk-adjusted basis.

Step 3: Assess ‘accidental’ bets caused by ESG screening

While the results above support the case for ESG investing, investors must take care to notice the geographical and industry bets that can arise from an ESG screening approach, say Alessandrini and Jondeau.

The researchers found that the more aggressive the ESG screening approach, the larger the resulting bias towards European and Pacific region stocks, and against US and emerging markets stocks.

This reflected the lower absolute ESG scores of firms in the US and emerging markets relative to those based in Europe and the Pacific region, they concluded.

Similarly, progressively excluding stocks with the lowest ESG scores leads to an underweighting of stocks in the financial and energy sectors and an overweighting of stocks in the information technology and industrial sectors, while also lowering exposure to the size factor and value factor premia.

Becoming stricter on ESG screening generally means loading up on large, profitable, and conservative companies, Alessandrini and Jondeau conclude. 

The Lyxor view

Investors rightly question whether a preference for sustainable, socially-responsible investing means giving up on opportunities for portfolio performance.

This research project suggests that the answer is no: based on analysis of the past performance of a universe of stocks from the MSCI All Country World index, a policy of exclusion based on companies’ ESG scores did not impact portfolio performance negatively.

In some cases, it led to superior risk-adjusted returns compared to the starting universe.

However, investors should be aware that ESG screening can result in geographical, sector and industry biases, such as a skew towards Europe and the Pacific, and to large, profitable, and conservative companies.

There is fertile ground for further research on the integration of smart beta and ESG, and in building algorithms that optimise the ESG profile of portfolios while keeping exposures to various risk factors under control.

Takeaways of part 3

  • ESG investors do not have to compromise on performance.
  • A positive screening strategy based on ESG scores can raise the ESG profile of both passive and active traditional and smart beta portfolios, without reducing risk-adjusted returns.
  • A screening strategy based on ESG scores, applied over the past 10 years, has led to substantial geographical and sectoral biases. 

1 ESG Investing: From Sin Stocks to Smart Beta Alessandrini, Jondeau, June 2019.

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