ESG investing in practice: Same return, lower risk
I have stated many times that I am advocating for ESG investing not because I think it creates higher returns, but because I think it is a form of extended risk management. Unfortunately, there are some new studies that cast some doubt on this view, as I have discussed here.
However, these studies are based on the performance of stocks in general. Another part of the equation is what investors who integrate ESG into their investment process really do. How does their performance compare to traditional investors? A new study tried to shine a light on this question by looking at the performance of institutional investors and asset managers who are signatories of the UN PRI. While the UN PRI is not without its critics, it remains the world’s largest scheme of ESG investors.
The research looked at the way ESG factors are used in the investment process of PRI signatories and found the usual unsurprising results. ESG integration in the investment process and engagement are the two most popular ways to integrate ESG factors into the investment process. 70% to 80% of the assets under management of PRI signatories have managed with ESG integration in place and the investors engage with company management to reduce ESG risks. Meanwhile, negative screening methodologies, that have rightfully been criticised as a performance killer and are increasingly abandoned by investors still cover about two-thirds of AuM. Other screens and thematic investments still play a minor role.
Assets under Management subject to ESG analysis
Source: Gibson et al. (2019).
What is also not surprising is that North American institutions typically apply ESG analysis to a lower share of AuM than institutions in Europe or Asia. This is both a reflection of the lagging acceptance of ESG analysis in the US and a different interpretation of the meaning of fiduciary duty. In the United States, fiduciary duty is still often interpreted as the duty to get the best returns possible for the lowest risk.
Well, for my US colleagues, I have news. Integrating ESG factors into your investment process does lower risks and thus increases risk-adjusted returns. The study looked at the returns of the 684 PRI signatories after fees and compared them to the returns of 6,481 similar non-signatory funds. What they found is that being a PRI signatory changes the influence of ESG on the investment process. And while this does not create higher returns (adjusted for all kinds of variables, the annual returns of PRI signatories and non-signatories differ by one or two basis points per year) PRI signatories have significantly lower volatility, and here in particular lower downside risks. Implemented properly, ESG investing does reduce risks in a portfolio without hurting returns. 684 institutional investors with $18.4tn assets under management show that it can be done.
Difference in return and risk of PRI signatories and non-signatories
Source: Gibson et al. (2019).