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Ethics & alpha: Can investing responsibly enhance returns?

In recent years researchers from both academia and the asset management industry, drawing on an ever-expanding universe of data, have conducted numerous studies to establish whether such a relationship exists.

According to researchers at the University of Hamburg and Deutsche Asset and Wealth Management, a positive relationship between ESG ratings and corporate performance was found in close to half of the 1816 academic studies published since 1970, with a negative correlation being found just ten per cent of the time. 1 For instance, a July 2013 Harvard Business School study found that over an 18-year period, a sample of ninety “high-sustainability” companies “dramatically outperformed” ninety low-sustainability firms in terms of both stock market and accounting measures. 2

Logical explanations

There are logical explanations as to why high, or improving, ESG ratings might boost investment returns.

Firstly, assets underpinned by high ESG ratings are likely to be less risky. For instance, while in the short term, firms may in some instances be able to get away with exploiting their customers or workforce, or degrading the environment, common sense suggests they will eventually be damaged by such behaviour.

Secondly, there is plenty of evidence to suggest highly-rated firms have a lower cost of capital. However, even if there are strong grounds for believing there is a relationship between ESG rankings and corporate performance, it has not always been clear investors have been able to profit from it in their portfolios.

ESG Integration does work

The rationale for doing so ultimately boils down to the extent to which you believe in the efficient market hypothesis – the idea asset prices fully reflect all available information and it is impossible to ‘beat the market’ consistently on a risk-adjusted basis.

In recent years investors have moved away from applying screens, of either the negative or positive variety, towards integrating ESG considerations into mainstream investment processes and areas such as impact investing.

Unfortunately – and perhaps one of main reasons why people still question whether ESG can add value – it is difficult to accurately quantify the value of embedding ESG considerations into the investment process. Since it is just one of multiple investment considerations disentangling its effect on fund performance from other factors is impossible to do in a purely objective way.

Nonetheless, there is overwhelming evidence ESG data can give investors valuable insight into how well a business is run, where its material risks lie and how sustainable its business model and practices really are.

Incorporating ESG criteria into the investment process can improve investment returns in other ways. Since the evidence suggests companies can create value by improving their ESG scores, it makes sense to engage with them to help improve their approach. For example, investors may wish to encourage an oil company to improve its safety record to lessen the danger of oil spillages, or to be more transparent in assessing the risks it faces due to climate change. Such improvements are likely to be rewarded by the market, even if not immediately.