We are experiencing a point in time where individuals and large institutions have been allocating more of their portfolio values in line with investment strategies that adhere to some degree of Environmental Social Governance criteria (ESG). More commonly known as ‘sustainable’ or ‘green’ investing.
According to the 2018 Global Sustainable Investment Review there has been a large-scale shift towards sustainable investing. Roughly 25% of US domiciled assets under management (AUM) were invested in some form of sustainable strategies.
The growth we are seeing in sustainable investing is good news, as growth in sustainable investments are directly linked to positive social economic impact. However, there are very important implications for expected investment returns.
In this weekly post we will be looking at how to align your investments with your views and values.
There are two main commonly known categories when it comes to sustainable investment strategies, namely Negative Screening and ESG Integration.
Eliminates certain industries, companies or general practices from a portfolio.
Re-weighting your portfolio. Meaning that the portfolio exposure will be underweighted in companies with lower ESG scores and overweighted in companies with higher ESG scores. This allows you to still have some exposure across various industries to maximize the diversity of your portfolio.
What you need to know about sustainable investing
- Does it effectively reflect your views and values?
- The impact on future expected return
This means that there is now a trade off at play. Are you willing to sacrifice potential returns to have a near perfect representation of your views and values? The most common case is where an investor does not seek to give-up the potential of having higher returns given that the sustainable investment strategy does not fully reflect their views and values.
The best place to start when considering a sustainable investment approach is the possible effects the approach will have on expected future returns. In a paper “The Contributions of Betas versus Characteristics to the ESG Premium” released in 2019, it was found that after considering 5 972 companies for the period of 2004-2018, companies with higher ESG scores had the tendency to reflect lower average returns than those with lower ESG scores.
It was found that one standard deviation decrease in the ESG score is linked with a 0.13% increase in monthly expected returns. In short, companies with lower ESG scores have higher average returns than companies with higher ESG scores.
Why would the returns be lower on sustainable investing strategies?
- ESG characteristics reflect investor preference
- ESG characteristics are captured by underlying risk factors
To simplify, it is most commonly found that it is an investor preference that drives the negative ESG premium (The higher the overall ESG score of the portfolio the lower the return would be to a lower ESG score portfolio). It is important to note that some investors are willing to accept lower expected returns, simply because they don’t want to invest in certain companies. This in itself is not a risk premium associated with ESG investment but simply different investor preferences.
In a 2007 paper, “Disagreement, Tastes and Asset Prices” it explains that investors may hold an asset partially as a consumption good, regardless of the expected return given that they have a preference for that asset. This means that if there is enough wealth controlled by investors with the same preferences (such as sustainable investors) the longer-term effect on prices could be potentially meaningful.
An oversimplified way to think of it is to say that investors who prefer sustainable investment would require a higher expected return to be convinced to invest in less sustainable companies. Which in turn drives up the expected return of ‘unsustainable companies.’
The Contributions of Betas versus Characteristics of the ESG Premium (http://www.gsi-alliance.org/wp-content/uploads/2019/06/GSIR_Review2018F.pdf)
Disagreement, Tastes and Asset Prices (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=502605)