Socially Responsible Investing: Profitable Or Just Feel-Good?

Socially responsible investing (SRI) is an increasingly popular approach to investing that takes into account the social impact and moral values of an investment, rather than prioritising financial return. While it may seem that choosing investments based on ethical standards could reduce financial returns, evidence suggests that this is not the case. In fact, socially responsible investments have been shown to perform as well as, or even better than, conventional investments. With growing concerns around climate change and social inequality, SRI is an attractive option for investors who want to support businesses that share their values and contribute to positive social and environmental change.

Socially responsible investing can bring positive long-term financial results

Socially responsible investing (SRI) is a type of investment that centres on social responsibility and environmental and corporate governance (ESG) factors. It is a growing trend, with assets invested based on sustainability expected to reach $40 trillion by 2030, up from $30 trillion in 2022. But does it make financial sense?

The evidence suggests that it does. Hundreds of studies have shown that, historically, SRI investments have performed as well as or better than their conventional counterparts. For example, Morningstar's 2022 Sustainable Funds US Landscape Report found that most sustainable funds outperformed their conventional counterparts. Data for the previous five years showed even better results, with 74% of sustainable funds ranked in the top half and 49% in the top quartile for returns.

In 2021, a study from Morgan Stanley Institute for Sustainable Investing found that funds that focused on ESG factors across stocks and bonds fared better than non-ESG portfolios in a year marked by volatility and recession. The research looked at more than 3,000 mutual funds and exchange-traded funds (ETFs) and found that sustainable funds performed better in 2020 and 2019.

A meta-analysis by the NYU Stern Center for Sustainable Business of over 1,000 studies on ESG and financial performance between 2015 and 2020 found that 59% of sustainable investments showed similar or better performance compared to conventional investments, while only 14% performed worse.

A report by the United Nations Environment Programme Finance Initiative in 2007 also found that SRI investment strategies had competitive performance with non-SRI strategies.

So, what are the financial benefits of SRI? Firstly, companies with strong ESG scores and socially responsible practices are seen as having thoroughly considered their future business strategy, thereby minimising exposure to risk. Secondly, socially responsible practices can reduce overall company costs and may even increase profitability by reducing the amount of resources required to operate. Thirdly, there is increasing demand for sustainable assets across all age groups, particularly from Millennials, and the markets tend to react positively to companies that take social responsibility seriously, which can positively impact their business performance.

In summary, SRI can bring positive long-term financial results. While there may be some downsides and difficulties, the evidence suggests that investors can achieve financial gains while also making a positive impact on society and the environment.

ESG scores do not indicate a company's positive impact on society or the environment

While ESG scores are a useful tool for investors to assess a company's sustainability and ethical performance, it is important to note that they do not necessarily indicate whether a company is making a positive impact on society or the environment. Here are some key points to consider:

• A common misconception about ESG ratings is that they measure a company's performance in non-financial areas. In reality, an ESG rating reflects how well a company manages the risk of not addressing environmental, social, and governance issues, which could impact its long-term financial performance.
• ESG scores are not regulated, and there is no standardised way of formulating them. Each rating agency uses its own criteria and may change them at any time. This lack of standardisation can lead to variations in scores for the same company across different rating agencies.
• ESG scores do not provide a black-and-white picture of a company's socially responsible practices. For example, a score may indicate that a company has a particular policy in place but does not show how well it is applied.
• The individual factors that contribute to an ESG score, such as a company's carbon footprint and labour practices, are combined and weighted to produce a single score. This means that a company's overall ESG score may not accurately represent its performance in specific areas.
• ESG scores are just one aspect of a company's performance, and investors should consider other factors such as financial performance and industry trends when making investment decisions.
• The lack of standardisation in methodologies and criteria used by rating agencies can make it challenging to compare scores across different providers.

In summary, while ESG scores can provide valuable insights into a company's sustainability and ethical performance, they should not be the sole indicator of a company's positive impact on society or the environment. Investors should consider ESG scores as one part of a comprehensive evaluation of a company's business practices and long-term prospects.

ESG ratings are not regulated

The lack of regulation around ESG ratings has been a cause for concern. While ESG ratings are important for investors and companies to make decisions about sustainable investments, the absence of regulation has led to a lack of standardisation and transparency in the ratings process.

Firstly, it is important to understand that ESG ratings are not a measure of a company's performance in environmental, social, and governance areas. Instead, they indicate how well a company is managing the risks associated with these areas and the potential impact on their long-term financial performance.

The issue with the lack of regulation is that each ratings agency uses its own criteria and methods for assigning a score. This results in a lack of consistency and comparability between different ratings agencies. A 2022 analysis by MIT Sloan and the University of Zurich found almost no correlation between ESG ratings from six different agencies due to the varying factors, weights, and measurement methods used.

The absence of regulation also leads to a lack of transparency, making it difficult for investors and companies to fully understand the ratings and the underlying methodologies. This can impact their decision-making process and ability to accurately assess the sustainability performance of a company.

Furthermore, without regulation, there is no standard way to address conflicts of interest that may arise from raters' relationships with the companies they rate. This can create an opportunity for greenwashing, where companies may present a false impression of their sustainability practices.

To address these concerns, the European Commission has introduced the first-ever set of rules focused on regulating ESG ratings. The goal of this initiative is to improve reliability, transparency, and comparability in the ESG ratings market. The new rules will require ratings agencies to disclose their calculation methods, provide more transparency around environmental, social, and governance factors, and be supervised by the European Securities Markets Authority (ESMA).

The regulation of ESG ratings is a positive step towards bringing more standardisation, transparency, and consistency to the market. It will help investors and companies make more informed decisions and foster confidence in sustainable investments.

Socially responsible companies may find it easier to raise capital

ESG scores are ratings from agencies such as FTSE ESG that indicate how well a company is managing the risk that not addressing ESG issues may have on its long-term financial performance. While these scores are not regulated and there is no standardised way of formulating them, they are still important to investors. Investors are increasingly using these scores to decide their investment strategies, and companies are responding by incorporating them into their business plans.

Assets invested based on sustainability are expected to reach $40 trillion by 2030, up from $30 trillion in 2022, according to Bloomberg Intelligence. This trend is particularly pronounced among younger investors, with 44% of respondents saying they are ready to invest more than a third of their savings in their own socially responsible investment portfolio.

The evidence, amassed through hundreds of studies, shows that historically, socially responsible investments have performed as well as or better than their conventional counterparts. For example, Morningstar's 2022 Sustainable Funds US Landscape Report found that most sustainable funds delivered stronger total and risk-adjusted returns than their conventional counterparts. Data for the previous five years showed even better results, with the returns of 74% of sustainable funds ranking in the top half and 49% in the top quartile returns.

In 2021, a study from the Morgan Stanley Institute for Sustainable Investing found that in a year marked by volatility and recession, funds that focused on ESG factors across stocks and bonds fared better than non-ESG portfolios. The research looked at more than 3,000 mutual funds and exchange-traded funds (ETFs) and found that sustainable funds performed better than non-ESG funds in 2020 and 2019.

A meta-analysis by the NYU Stern Center for Sustainable Business of over 1,000 studies on ESG and financial performance between 2015 and 2020 found that 59% of sustainable investments showed similar or better performance compared to conventional investments, while only 14% performed worse.

Generally, responsible funds have not underperformed against traditional funds over the long term

This is supported by a meta-analysis by the NYU Stern Center for Sustainable Business of over 1,000 studies on ESG and financial performance between 2015 and 2020, which found that 59% of sustainable investments showed similar or better performance compared to conventional investments, while only 14% performed worse. This supports the idea that responsible funds have not underperformed against traditional funds over the long term.

The evidence, amassed through hundreds of studies, shows that historically, SRI investments have performed as well as or better than their conventional counterparts. For example, Morningstar's 2022 Sustainable Funds US Landscape Report found that most sustainable funds delivered stronger total and risk-adjusted returns than their conventional counterparts. Data for the previous five years showed even better results, with the returns of 74% of sustainable funds ranking in the top half and 49% in the top quartile returns.

In 2021, a study from the Morgan Stanley Institute for Sustainable Investing found that in a year marked by volatility and recession, funds that focused on environmental, social and governance (ESG) factors, across both stocks and bonds, weathered the year better than non-ESG portfolios. The research looked at more than 3,000 mutual funds and exchange-traded funds (ETFs) and found that sustainable funds performed better than non-ESG funds in 2020 and 2019.

While there are some downsides to socially responsible investing, such as higher start-up costs and less investment choices, the evidence suggests that responsible funds have not underperformed against traditional funds over the long term.

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