The myth of ESG outperformance

Asset Class in Focus

Part two of a look at the hype surrounding the ESG theme finds that there are sound reasons to be skeptical about claims that ESG investments outperform the general market.

A confused investment theme

There is no single standard ESG term that is used consistently when attempting to measure performance of ESG funds. Instead, a jumble of terms that are not clearly distinct are confusing and easily conflated.

In addition to ESG, variations include socially-responsible investing (SRI), ethical investing, impact investing, corporate social responsibility (CSR) screening, sustainable investing. There is also the catch-all word “green” as in “green bonds”, a product that has had stepped up marketing efforts recently.

It is doubtful all these terms have discrete definitions and if an investor or a fund manager were challenged for clarification, a handbook of terms would have to be consulted.

How are ESG scores different from an SRI evaluation, or is there a difference? Are ESG investments and incorporating “principles for responsible investing” (another layer of confusion known as UNPRI) into investment decisions basically the same thing? How are companies with high CSR ratings different from impact investments? Are responsible and sustainable investing the same thing?

But the confusing terminology is more than a nuisance. It allows researchers to cherry-pick the term to achieve performance results that conveniently support a conclusion.

For example, “ethical investing” refers to exclusionary screening of morally-offensive investments (such as weapons manufacturers).

Over the trailing five years, the equity fund category in FE labelled “ethical”, comprised of 142 funds, underperformed the MSCI World Index, as well as the S&P 500.

 

 

However, if “SRI” is the chosen term for ESG performance analysis, MSCI has an index for it and the results are better.

From September 2007 to August 2017, in cumulative gross returns, the MSCI World SRI Index outperformed the MSCI World 162.58% to 156.43%.

But the data may be skewed by the fact that the SRI Index has so far in 2017 beat the MSCI World 14.5% to 13.9%. The annualised returns since 2008 tell another story. It has underperformed the broader stock index five out of nine years. Moreover, in the four years that the SRI index “beat” the broader world market, it was typically a slight edge:

 

MSCI World SRI IndexMSCI WorldSRI scorecard
2016 8.36% 8.15% +
2015 -1.05 -0.32 −
2014 4.45 5.50 −
2013 28.04 27.37 +
2012 13.95 16.54 −
2011 -5.01 -5.02 +
2010 11.17 12.34 −
2009 33.10 30.79 −
2008 -37.60 -40.33 +
 Source: MSCI

 

The weak champions

Why play around with the jumble of terms when examining ESG returns? For the best possible outcome, the focus should be on “ESG leaders”. These companies have the highest ESG scores (using so-called positive screening). They are the best of the best and therefore, on average, should demonstrate a clear tendency to consistently beat the general market.

However, that is not what the data shows.

From September 2007 to August 2017, the MSCI World ESG Leaders Index underperformed (155.13%) the MSCI World (156.43%), which represents the “broader universe of stocks” that is often referred to in ESG performance reports.

In fact, these “leaders” have hugged the index for a decade.

 

Source: MSCI

But maybe the touted outperformance will be reflected regionally?

Unfortunately, the results are mixed and taken together do not support claims that ESG companies beat the wider stock market.

Ten-year performance of the ESG Leaders vs the market

MSCI World ESG Leaders155.13%MSCI World156.43%underperform
MSCI USA ESG Leaders357.81%MSCI USA371.09%underperform
MSCI Europe ESG Leaders118.77%MSCI Europe114.46%slight outperform
MSCI EM ESG Leaders174.01%MSCI EM118.24%clear outperform
Source: MSCI. Time frame is September 2007 – August 2017 except for MSCI USA, which is August 2002 — August 2017.

 

Cheating, undetected?

Results suggest an ESG investor would have the best chance of beating plain vanilla stocks by putting capital in emerging market “ESG Leaders”.

But the performance claims of ESG proponets are never that specific, and in any case the emerging markets argument has some holes in it.

First, the outperformance in emerging markets but not in other regions rasies doubts as to whether the ESG element is actually a performance driver. If it is, results should be evident in all regions.

Second, is long-term company growth due to implementation of ESG policies or to violating them?

Multiple companies may be cheating on their ESG commitments, enhancing their profits and therefore driving ESG index performance. The Volkswagen emissions scandal has shown that ESG scoring methods failed to detect poor governance and instead indices and industry accolades showed the company ranking high on governance – the “G” in ESG.

In developed markets, analysts, NGOs, institutional investors, the media and the general public have been long-established as ESG watchdogs.

Yet despite the excessive scrutiny, Volkswagen, and likely the other carmakers under investigation, still cynically exploited ESG polices and went undetected for many years.

In emerging markets, both institutional and public awareness of ESG is far less mature than in developed markets and therefore more open to exploitation. From an EM company perspective, adoption of ESG principles is voluntary and it involves operational costs. Cheating on them (if no laws are broken) carries no legal consequences.

Trust has eroded after the emissions scandal. Investors should be wary of claims that ESG (or sustainable, ethical, impact, green, SRI or whatever) companies beat the broader equity market and verify the actual source of any purported outperformance.

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