ESG Funds Perform Better

If investors want to maximise returns, then they should ensure environmental, social, economic, and financial system in which they invest is as healthy as it can be

David Harrell 23 February, 2018 | 3:20PM

Sustainable investing, evaluating companies on the basis of ESG; environmental, social, and governance factors, isn’t new. The concept of socially responsible investing dates back to the 1970s, and it’s been nearly two years since Morningstar introduced a Sustainability Rating for mutual funds. Using company level ESG data from Sustainalytics, Morningstar assigns mutual funds Sustainability Ratings from 1 to 5.

The topic has garnered headlines recently after the release of this year’s letter to CEOs from Larry Fink, founder and CEO of BlackRock, the world’s largest asset manager. In the letter, Fink called for a “new model for corporate governance” and announced plans to double the size of BlackRock’s investment stewardship team.

We sat down with Jon Hale, Morningstar’s director of sustainability research, to discuss the topic.

David Harrell: One misconception is that sustainable investing simply means sector or industry avoidance, but that’s not necessarily the case. The Morningstar approach is based on evaluating companies, and the funds that invest in them, based on how well they’ve addressed the environmental, social, and governance risks they face, correct?

Jon Hale: Yes, when we think about ESG today, it’s about applying these different metrics that relate to environmental or social or corporate governance issues to a company and asking yourself how well that company is managing those considerations. Every single ESG factor that you might conceive of is not material to every single industry or sector.

Harrell: And within the Morningstar methodology you helped develop, you’re not penalising companies for the industries or sectors they’re in?

Hale: It’s a best-in-industry approach. The way that Sustainalytics approaches the equity universe is by breaking it down into about 150 industry groups, and within each industry group it assesses what are the key material environmental, social, and governance issues. Governance issues are more uniform across industries.

But environmental and social issues are generally a unique mix for every industry group, based on what’s material to the companies in the industry and what’s most impactful from an externality standpoint for those industries.

Harrell: Some suggest investors pay a price for using an ESG or sustainable approach. For example, in a recent Wall Street Journal editorial, a hedge fund manager wrote that the basic idea outlined in Fink’s letter was to “throw money away.” Yet I believe at one point you had research showing that an ESG approach often correlated with higher performance ratings for funds.

Hale: We’ve found that funds that explicitly embrace ESG as part of their prospectus, we call them intentional ESG funds, do tend to have better star ratings. That means their risk-adjusted returns within their category tend to be a little better than what you’d expect for the overall universe. The thing about integrating ESG into an investment process is that there are all kinds of ways to do it.

There’s a wide range of ways to do it, so it’s interesting from a performance standpoint that, on the whole, for mutual funds that do ESG in some way, there’s a positive performance skew on a risk-adjusted basis. I think ESG adds to a more complete financial analysis of a company, but it’s not really about investing with your beliefs per se.

The original way of thinking about socially responsible investing was you can align your portfolio with your beliefs. ESG analysis came along saying there are these risks and opportunities that companies face related to issues that aren’t yet reflected in the financial statements. And a lot of these have to do with various environmental issues that a company has to deal with or social issues, not whether they make tobacco or are involved in gambling or alcohol. How do they oversee their supply chain? How do they manage their human capital and product safety?

Those are the kind of issues ESG analysis tries to focus on, as well as the best practices of corporate governance. That really doesn’t have anything to do with aligning your values, other than saying “I want to invest in good, high-quality companies.”

Today, investors as well as consumers are increasingly saying to companies, “We want you to pay attention to the impact.” Really what Larry Fink is saying is that if long-term investors want to maximise their returns, then it may be in their best interest to make sure that the global environmental, social, economic, and financial system in which they invest is as healthy as it can be.

Harrell: Even though BlackRock has a huge influence via its proxy votes, you recently wrote that the Fink letter simply reflects what’s already happening.

Hale: I think a lot of companies – depending on the industry, of course – are starting to figure out how climate change might affect them and their business, and whether it’s purely a set of risks they have to deal with, or in some cases, there may be huge opportunities. In a way, sustainability is something like a big macro theme.

I think as a lot of companies are looking to and planning for the future, it’s tied up in a lot of sustainability issues; how do we deal with climate change, how do we make better, safer products, how do we improve conditions in the world? I think they’re starting to think about their impact, to make sure that they continue to be profitable enterprises going forward.

Harrell: We’ve received email from subscribers who are worried that certain holdings such as tobacco stocks or master limited partnerships are being targeted by ESG activists and their stock prices are being hindered by it. Do you see any evidence or examples of this?

Hale: Not particularly. Clearly there was a period when there was a coalition of investors, consumers, activists, and regulators who went after tobacco companies. But that’s already been long priced into the stock prices of tobacco companies. It’s not just an investor thing, in my opinion. I think these are broader societal trends that can impact an industry that is not making safe and useful products. One thing we’re seeing today is companies like CocaCola are starting to feel some of the same kind of pressure from the public health coalition to do something about nonhealthy products.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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David Harrell  David Harrell is the editor of ClearFuture.