Investors worldwide are increasingly becoming aware about the environmental, social and governance (ESG) footprint of companies. Think about energy efficiency and positive community contribution or, at the other extreme, oil spills and corporate scandals. As these issues impact company stock prices over the medium-to-longer term, there is a case for investors to allocate at least some of their holdings after analysing the likely environmental and social impact of their target companies.

The expanding field of ESG investing applies a set of agreed criteria to select companies on the basis of corporate sustainability. Examples of common criteria include those agreed at the UN Global Compact, UN Principles for Responsible Investing (PRI) and Sustainability Accounting and Standards Board.

‘Sustainability’, as an investment approach, is now a well-researched approach to investing, with one study arguing that more than 20 percent of global assets are now managed in the ‘sustainable and responsible’ way. Moreover, the awareness of ESG issues has grown considerably over time as evidenced by the rising use of ESG data. According to Bloomberg, the number of its customers using ESG data grew from 2,415 in 2009 to 17,010 in 2014.

The reasons for adopting a ‘sustainable’ investment approach can vary and this may not be performance-oriented alone. Some investors may see ESG as a way to simply enhance investment returns. Others may see this as an investment approach that is consistent with their values or beliefs, where a simple risk-return framework may not be always applicable. For example, an investor may choose to avoid investments in alcohol, tobacco or gambling as they may find these socially objectionable. 

There are many approaches when it comes to applying ESG to an investment strategy. The initial efforts tended to concentrate on an ‘exclusionary’ approach, which screen the investible universe with these criteria before applying any other investment decision-making processes to this reduced universe, often at an industry level. The main downside of this approach is blindly screening out potentially strong sources of investment performance. More nuanced approaches, instead, incorporate ESG as an additional factor within a broader investment decision-making process, or actively work with companies to improve their sustainability scores. 

We see ESG as a strategy that can help achieve three goals: outperform the broader market in select situations, reduce drawdown risk and ensure more socially responsible investing for a given investment allocation. 

The evidence on whether an ESG-based investment strategy leads to outperformance relative to a global equities benchmark is mixed. While a majority of studies argue there is a reasonably high chance adding an ESG criteria can lead to better investment returns over time, this is often sensitive to whether ESG criteria are used to simply screen out investments that do not meet the criteria or whether they are used as an additional factor as part of a broader investment process. Where the evidence appears more compelling is that incorporating ‘sustainability’ as a criterion appears to support improved corporate performance in specific parts of the market, such as bonds, real estate and emerging market equities.

Regardless of one’s view on ESG’s contribution to outperformance, there is less doubt that incorporation of sustainability factors leads to improved risk management. Studies suggest ESG-compliant firms face lower costs of capital and a low risk premium due to greater transparency. Such firms tend to face a lower risk of their assets becoming ‘stranded assets’ or worthless. For an investor, this means that even if returns with and without ESG factors are similar, the same return may be obtained by taking less risk. 

Many investors seek more than just investment returns from their investment allocations. There is much evidence that incorporation of ESG factors does not impose additional costs from an investment return point of view. This means, the investors interested in ensuring their financial investments, also have a positive sustainability impact, are able to achieve this goal via ESG strategies without having to take on a financial cost in terms of lower investment returns.

ESG investing does not come without its own risks. One critique comes from studies that show that active exclusion of ‘sin’ sectors (such as alcohol and tobacco) can detract from performance over time. A greater share of the market trying to meet the ESG criteria means it will mathematically become harder and harder for the approach to outperform. Nevertheless, on balance, we believe the positive characteristics of ESG investing outweigh the risks, causing us to take a constructive view on incorporating ESG into one’s investment strategy. 

(Manpreet Gill is Head of Fixed Income, Currency and Commodity Strategy at Standard Chartered Bank)