Finding the Intersection of ESG and Performance

Environmental, social and governance metrics have been put in place to help companies improve the social and environmental sustainability of their business practices. But for an investor, actually tracking a company’s ESG performance can sometimes provide unexpected results.

According to Morningstar’s most recent “Global Sustainable Fund Flows” report, which tracks exchange-traded funds that claim to have a sustainable investment objective or use binding ESG criteria for their investment selection, total assets expanded by 9% in the fourth quarter and ended at $2.74 trillion at the end of December. Inflows grew as well, as investors added $142 billion into sustainable funds globally, a 12% increase from the third quarter.

Views abound as to what the performance implications are for ESG investing, while interest in ESG is growing—not just in retirement, but across the board, says Michael Hunstad, Northern Trust Asset Management quantitative strategies head. It can be tempting, he says, to draw conclusions about whether ESG will help or hurt portfolio performance by comparing it relative to a benchmark, but that may not draw a clear picture.

Plenty of companies rank highly in ESG but don’t necessarily have a good financial picture when it comes to their profitability, cash flow or balance sheets, Hunstad says. Ideally, an investor would want to invest in a company that is in a good financial position with a positive ESG orientation, and discussion should center around those two dimensions.

“Our thesis is that you want to invest at the intersection of the two, so you want highly rated ESG companies, absolutely, but you also want those companies that have good financial positioning,” Hunstad says. “These are the firms that, through time, have done very well from a return perspective. They tend to be less risky and have some downside protection associated with them as well.”

When choosing an investment strategy that integrates ESG factors, either actively or passively, there are two very different approaches, says John Hoeppner, U.S. stewardship and sustainable investments head at Legal & General Investment Management America. He says it can be hard to get a straight answer on how much ESG factors influence active investment decisions, because the decision methodology varies depending on the analyst, portfolio manager, strategy or firm.

When a manager integrates ESG into passive investing, the process is generally going to be quantitatively driven.

“Companies that have, on average, a better ESG profile, get a higher weighting, while companies that get a worse ESG profile get a lower weighting,” Hoeppner says. “The purpose of that is to, in the long run, outperform the market index. Our view is that companies with broadly positive ESG characteristics are more resilient, and they better avoid risk. These considerations are baked into that quantitative model.”

LGIMA uses one methodology that tilts for 28 different ESG factors, Hoeppner says, but they also have indexes that can tilt specifically for climate or social diversity.

“Inside the ‘G,’ there is a host of governance sub-factors that are considered, such as board independence or the tenure of directors—or the independence of the auditor,” Hoeppner says. “You can look at the ‘S’ factor, which is influenced by the levels of diversity at the board level and among executives and managers. With the ‘E,’ the focus is on the environment, on things like carbon emissions and the percentage of green revenues.”

Using these factors in a passive investment strategy allows an investor to see precisely how much influence each one has, Hoeppner says. Clients then have a clearer picture to help them decide how much risk they are willing to take on and what level of performance they are pursuing, among other things.

Hannah Herold, American Century Investments’ ESG research director, explains that ESG factors are non-financial factors that could have a material financial impact on a company. One important theme in her research is that, just because a certain macro risk exists, this doesn’t mean that all companies are experiencing that risk in the same way.

For example, a company could have very robust policies, audits and top-of-the-line security systems, Herold says. In that situation, she says, the company could be exposed to cybersecurity risk but actually manage it better than a different company would. Such considerations can help to inform investment decisions.

“By looking at these things, we could potentially guard against something like a cyberattack, and all of the costs and reputational damages and potential loss of client data that could go along with that and hurt the investment,” Herold says.

In a recent Harvard Business Review blog post, Sanjai Bhagat, University of Colorado professor of finance, suggests that investors have not necessarily fared well when investing in ESG funds. Citing research from the University of Chicago, he points out that the highest-rated funds in terms of sustainability attract more capital than the lowest-rated funds. But this does not mean the high-sustainability funds reliably outperform the lowest-rated funds.

Bhagat points to the importance of looking beyond labels and subjecting ESG funds to the same level of scrutiny that is brought to bear in the review of other investments. He points to analyses that have shown companies in some ESG fund portfolios actually had worse compliance records for both labor and environmental rules relative to excluded companies.

Why are ESG funds facing such issues? Part of the explanation may simply be that an express focus on ESG is redundant, Bhagat says.

“In competitive labor markets and product markets, corporate managers trying to maximize long-term shareholder value should of their own accord pay attention to employee, customer, community and environmental interests,” he proposes. “On this basis, setting ESG targets may actually distort decisionmaking.”