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ASI’s David Smith examines whether following ESG principles means sacrificing returns

“The evidence shows there is no ‘sacrifice’ of returns for strong ESG principles”, says David Smith, Senior Investment Director at Aberdeen Standard Investments.

Investors say they want to invest in companies with strong environmental, social and governance (ESG) credentials, and asset managers are keen to offer these investments, but the suspicion remains that ESG investments may not perform as well as ‘traditional’ investments.  Does following ESG principles mean returns must be sacrificed?

To answer this question conclusively, we’ve looked through extensive research to find out how ESG factors affect the medium and long term performance of companies and portfolios.

It turns out that committing to ESG has a much more positive outcome for business, employees, customers, the natural environment, the climate and returns for investors, than may previously have been thought. We’ve looked through the academic research and concluded that ESG principles bring significant value. Analysis by MSCI of over 1,600 companies from the MSCI World Index universe, between January 2007 to May 2017, sorted companies into five ESG score quintiles: Q1 companies had the lowest ESG rating and Q5 the highest. Highly rated (Q5) firms were more profitable and paid higher dividends than lower rated firms (those in Q1). Highly rated firms also demonstrated lower earnings volatility and lower systematic volatility.

Strong ESG and lower risk

In addition, we discovered correlation between a robust ESG score and the following qualities: profitability, share price growth, and a lowering of risk, at both the portfolio and the stock level. Another benefit for higher scoring  companies is that they can obtain both debt and equity capital at a lower cost.

Further proof that strong ESG credentials are beneficial comes from research which demonstrates that companies with these credentials perform better in times of volatility. Data from 2004-2018, and from the Covid crisis of 2020, showed companies with higher ESG scores were more resilient during volatility, suggesting ESG credentials improve a company and a portfolio’s risk-adjusted return.

It would appear that ESG integration reduces portfolio risk across every kind of market and investment style. Over longer time frames, this positive ESG effect is enhanced.

Emerging markets

Robust ESG has a particularly positive effect in the emerging market space, where the relationship between company performance and a good ESG scorecard is positive.  A meta-analysis of over 2,200 research papers on ESG integration found a convincingly positive relationship between ESG and corporate financial return. For emerging markets, the 65-71% positive corporate financial outcomes revealed is much higher than that of developed markets (38-50%).

Investing in emerging markets is challenging because often there is less regulation and less available information around the companies. So for potential investors, if an investment displays robust ESG factors, this becomes material. Moreover, ESG principles give investors a defined framework to research an emerging market company. If a company is well managed – treating workers well, avoiding pollution, focusing on energy and waste management, it will usually have stronger results, in both the short and long term.

Active managers and ESG research

 David Smith, Senior Investment Director, Aberdeen Standard Investments, comments: “We believe asset managers have a responsibility to help companies improve their ESG standards by actively engaging with them.  We now have the evidence to show that it’s no longer correct to believe that  ESG is ‘a nice add-on’, or an ’added luxury’ that brings nothing in return. In fact, we are convinced that companies that don’t look after their people, their customers, or their impact on the environment are unsustainable businesses that increasingly may not be worth investing in.”

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