Esg Investing: Factor Or Guide?

Environmental, Social and Governance (ESG) criteria are used to evaluate a company's sustainability and to encourage companies to act responsibly. ESG investing is a way to build a more ethical portfolio, with investors increasingly applying these non-financial factors to identify risks and growth opportunities. However, the question remains: is ESG an equity factor or just an investment guide?

ESG criteria and equity portfolio returns

Environmental, Social, and Governance (ESG) criteria are used to evaluate a company's sustainability and are considered during investment decisions. ESG investing is a form of sustainable investing that considers environmental, social, and governance factors to judge an investment's financial returns and overall impact.

ESG criteria are not commonly part of mandatory financial reporting, but companies are increasingly disclosing this information in their annual reports or standalone sustainability reports. The three main components of ESG are:

• Environmental: This includes factors such as conservation of the natural world, climate change, carbon emissions, air and water pollution, customer satisfaction, data protection, and gender and diversity.
• Social: Social criteria examine how a company manages relationships with employees, suppliers, customers, and communities. This includes workplace conditions, health and safety, and community involvement.
• Governance: Governance looks at the standards for running a company, including leadership, executive pay, audits, internal controls, and shareholder rights.

ESG investing can be seen as a way to build a more ethical portfolio and encourage companies to act responsibly. It is sometimes referred to as sustainable investing, responsible investing, impact investing, or socially responsible investing (SRI).

While ESG criteria are important for investors who want to make ethical choices, it is also worth considering the potential impact on financial returns. A study by André Breedt et al. found that incorporating ESG criteria into a worldwide equity market neutral portfolio did not yield additional returns. However, it is important to note that it also did not hurt returns. This suggests that while ESG may not be considered a unique equity factor, it can be incorporated into investment decisions without sacrificing financial returns.

Other studies, such as one by the Morgan Stanley Institute for Sustainable Investing, compared the performance of sustainable funds with traditional funds and found similar total returns from 2004 to 2018. Additionally, sustainable funds were found to have lower downside risks during turbulent markets. ESG funds have also performed strongly in recent years, with 24 out of 26 sustainable index funds outperforming comparable traditional funds in the first quarter of 2020, according to Morningstar.

In conclusion, while ESG criteria are important for investors who want to encourage sustainable and ethical business practices, it is not necessarily a unique equity factor that will significantly impact portfolio returns. However, incorporating ESG criteria can help investors make more informed decisions and avoid companies engaged in risky or unethical practices without sacrificing financial returns.

ESG as a unique equity factor

ESG, or Environmental, Social, and Governance, is a set of criteria used to evaluate a company's or investment's sustainability. It is a framework that companies use to evaluate their sustainability and for investors to screen investments.

The three main components of ESG are:

• Environmental: This includes factors such as conservation of the natural world, climate change, carbon emissions, air and water pollution, customer satisfaction, data protection, and gender and diversity.
• Social: This includes a company's relationships with internal and external stakeholders, such as employees, suppliers, customers, and communities. It also covers areas like workplace health and safety, community involvement, and ethical supply chains.
• Governance: This covers how a company is run, including leadership, executive pay, audits, internal controls, and shareholder rights. and board diversity.

While ESG has gained widespread acceptance as a way to enhance returns and encourage responsible business practices, some argue that it should not be considered a unique equity factor. A study by André Breedt and others, which incorporated ESG criteria into a worldwide market-neutral portfolio, found that it yielded no additional return. They concluded that any benefits from tilting towards a better-rated ESG portfolio are already captured by other well-known equity factors.

However, the study also showed that incorporating ESG criteria did not hurt returns. This suggests that while ESG may not be a unique equity factor, it can still be a valuable tool for investors to assess potential investments and manage risk.

ESG and socially responsible investing

Environmental, Social, and Governance (ESG) criteria are used to evaluate a company's sustainability and to screen investments. ESG investing is a form of sustainable investing that considers environmental, social, and governance factors to judge an investment's financial returns and its overall impact.

ESG investing is sometimes referred to as socially responsible investing (SRI), although there are some differences between the two. SRI is an investment strategy that highlights one facet of ESG. While both approaches seek to build more responsible portfolios, SRI uses an exclusionary-only approach to filter out investments considered immoral, such as tobacco or alcohol companies. In contrast, ESG investing excludes these companies but also includes those deemed to be creating a positive impact.

ESG criteria cover a range of factors, including:

• Environmental: Climate change policies, energy use, waste, pollution, natural resource conservation, and treatment of animals.
• Social: A company's relationships with internal and external stakeholders, including employees, suppliers, customers, and communities.
• Governance: Leadership, executive pay, audits, internal controls, and shareholder rights.

ESG investing can help portfolios avoid holding companies engaged in risky or unethical practices. It can also provide potential high returns, with some studies showing that ESG investments can outperform conventional ones.

However, a 2018 study by André Breedt and others found that incorporating ESG criteria into a worldwide equity market neutral portfolio did not yield additional returns. The study concluded that ESG should not be considered a unique equity factor but rather an investment guide.

ESG ratings and scoring systems

Environmental, Social and Governance Factors

ESG scores evaluate companies based on various criteria, which are classified into three main categories: environmental, social, and governance.

Environmental Issues

• Renewable energy usage
• Pro-diversity efforts
• Board diversity and structure
• Executive compensation
• Supply chain management
• Climate change and carbon emissions
• Air and water pollution
• Customer satisfaction
• Data protection and privacy
• Gender and diversity

Social Scoring Factors

• Business relationships with employees, suppliers, partners, shareholders, and other groups throughout the supply chain
• Worker treatment in factories abroad
• Whether employees earn a living wage
• Workplace safety and regular inspections
• Leave policies for sickness or personal reasons
• Charitable contributions, customer interactions, community impact, and policy influence

Governance Scoring Criteria

• Legal and compliance issues
• Board operations and diversity
• Executive and non-executive compensation compared to the company's peers

ESG Rating Agencies and Methodologies

There are numerous ESG rating agencies and data providers, each with its own unique methodology and set of criteria for evaluating companies. Some of the most prominent ESG rating agencies include:

• Bloomberg ESG Data Services
• Corporate Knights Global 100
• Sustainalytics ESG Risk Ratings
• Dow Jones Sustainability Index Family
• Thomson Reuters ESG Scores
• RepRisk
• S&P Global
• ISS-Ethix ESG
• CDP Scores
• Climetrics
• Vigeo Eiris (Moody's)
• FTSE Russell ESG Scores

Limitations of ESG Scores

Despite being a valuable tool for investors, ESG scores have several limitations that should be considered:

• Lack of standardisation in methodologies and criteria used by different rating agencies.
• Potential for greenwashing, where companies may misrepresent or exaggerate their ESG efforts.
• Reliance on self-reported data by companies, raising concerns about data quality, accuracy, and reliability.
• Inability to capture all relevant aspects of a company's sustainability performance due to limitations in data availability or methodology.
• Limited coverage of small-cap and mid-cap companies, which could restrict the investment universe for responsible investors.

ESG funds and stock options

ESG stands for Environmental, Social, and Governance. It is a set of criteria used to evaluate a company's responsibility metrics and standards. ESG funds are pooled investment portfolios that own sustainability-focused companies and organisations.

ESG funds invest in companies that actively manage their environmental, social, and governance risks. These companies commonly pursue a range of sustainability goals, such as improving energy efficiency, forming social advancement opportunities within their communities and workforces, preventing human rights violations throughout their supply chains, enforcing ethical business practices, and creating board independence and reporting transparency.

ESG funds can be mutual funds or exchange-traded funds (ETFs). When you buy shares in an ESG fund, you own a slice of the fund's holdings and participate in the fund's performance.

• IShares ESG Aware MSCI USA ETF
• IShares ESG Aware MSCI EM ETF
• Vanguard ESG U.S. Stock ETF
• IShares MSCI Global Sustainable Developmental Goals ETF
• Fidelity U.S. Sustainability Index Fund

ESG funds can help investors align their investments with their values and support companies that prioritise sustainability, social responsibility, and good governance. However, it is important to note that ESG investing does not guarantee superior financial returns, and there may be a trade-off between values and returns.

Frequently asked questions