Research Affiliates: Unlocking The Performance Potential In ESG Investing

March 30, 2018

Key Points

  • The demand for socially responsible investing strategies is growing as a means to manage environmental, social, and governance (ESG)–related risks—which can impact long-term returns—and as an opportunity to promote social and environmental issues, but much remains unknown about the performance potential of these strategies.
  • Research identifies two ESG metrics linked to good corporate governance, which have the potential to drive performance: notably, financial discipline and diversity.
  • Rebalancing positions using thoughtful smart-beta product design is a powerful market-tested return enhancer. Combined with the two forementioned performance-driving firm attributes, it is a proven way to construct an ESG strategy with strong long-term return potential.

Socially responsible investing strategies, which use environmental, social, and governance (ESG) criteria to position portfolios, are increasingly popular around the world. Socially responsible goals are lauded by most investors, but questions remain about the investment merits of strategies that constrain the portfolio construction process. Thus, many ESG-oriented investors face an uncertain tradeoff between social responsibility and investment performance. A growing body of research, however, has identified a set of company characteristics directly aligned with the tenets of ESG investing and associated with superior financial outcomes. Two of these, financial discipline and corporate diversity, top the list of governance-related metrics with potential positive performance implications. Combining a tilt toward companies that display these characteristics with the return engine of a fundamentally weighted portfolio presents the opportunity to earn superior long-term risk-adjusted returns for ESG-minded investors.

“…we firmly believe that investors do not need to abandon investment performance to achieve their ESG objectives.”

Socially responsible investing (SRI), also called sustainable investing, is an approach that considers environmental, social, and governance (ESG) criteria in making portfolio construction decisions.1 Investors are attracted to SRI as a means to manage ESG-related risks—which can impact long-term returns—as well as an opportunity to promote social and environmental issues. As a result, demand is growing for attractive investment strategies that can satisfy the dual objectives of social responsibility and long-horizon outperformance.

We believe these dual objectives can be met by introducing two elements that go beyond the machinery of traditional ESG strategies. The first element is to supplement standard ESG metrics with performance-driving firm attributes directly linked to ESG principles; in particular, this is the degree to which a firm possesses the financial discipline to generate sustainable long-term performance for its shareholders rather than make decisions to benefit its managers in the short run—essentially, acting as a bedrock of good governance—as well as the level of diversity among a firm’s ranks (to date, most often measured by its diversity in terms of gender).

Although limited data availability makes it difficult for researchers to draw conclusions from standard econometric tests, and much remains unknown about the performance potential of traditional ESG metrics, we find considerable research support for both financial discipline and diversity, with financial discipline more obviously and more practically amenable to traditional empirical tests than diversity, at least to this point in the research.

The second element is to apply thoughtful smart-beta product design and implementation techniques to an ESG strategy. For example, using the market-tested smart-beta portfolio construction technique of fundamental weighting, which breaks the link between portfolio weights and stock prices, allows us to capture the return engine of systematically rebalancing back to stable anchor weights, and spreading out trading over a period of days to preserve that rebalancing return through low implementation costs.

In this article, we summarize our understanding of the research related to the investment implications of ESG investing and present a case for how investors can meet both their social responsibility and investment objectives with a thoughtfully designed investment strategy.

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