Swedroe: ESG Strategy Performance

Investors tend to sacrifice returns regarding socially responsible strategies. 

Equity strategies that target environmental, social and governance (ESG) issues consider not just their stock returns but the effects their investments have on other stakeholders, such as employees and individuals affected by the environmental decisions of those firms. ESG strategies have exploded in popularity.

As of October 2018, assets tied to ESG products stood at about $12 trillion. That’s an increase of 38% from $8.7 trillion in 2016. In the U.S., ESG now accounts for about 25% of professionally managed assets.

The US SIF Foundation’s 2018 biennial Report on US Sustainable, Responsible and Impact Investing Trends cited this surge in client demand as the reason asset managers are increasingly looking to integrate ESG into their offerings in some form. Leading index providers have been creating investable indices for the investment community.

Concurrently, the market for proprietary ESG scoring of stocks has grown. Many prominent data vendors now provide coverage on stocks from an ESG lens in some form.

MSCI’s ESG Benchmarks

One of the leading providers of indices, MSCI, now has several ESG indices. As stated on its website, “Indexes are designed to support common approaches to ESG investing, and help institutional investors more effectively benchmark to ESG investment performance as well as manage, measure and report on ESG mandates.”

The MSCI ESG Ratings are constructed based on thousands of data points across 37 ESG key issues, focusing on the intersection between a company’s core business and the industry issues that can create significant ESG related risks and opportunities. Companies are rated on a AAA-CCC scale relative to their industry peers. For example:

• The MSCI USA ESG Select Index is designed to target companies with positive ESG factors while exhibiting risk/return characteristics similar to those of the MSCI USA Index. The index is constructed through an optimization process that aims to maximize its exposure to ESG factors, subject to an expected tracking error of 1.8% and other constraints. It is sector-controlled and designed to overweight companies with high ESG ratings and to underweight companies with low ratings. Tobacco and controversial weapons companies, as well as major producers of alcohol, gambling, firearms, military weapons and nuclear power, are not eligible for inclusion.

• The MSCI USA ESG Leaders Index is a capitalization-weighted index that provides exposure to companies with high ESG performance relative to their sector peers. MSCI USA ESG Leaders Index consists of large and midcap companies in the U.S. market. The index is designed for investors seeking a broad, diversified sustainability benchmark with relatively low tracking error to the underlying equity market.
• The MSCI USA ESG Universal Index is based on the MSCI USA Index, its parent index, and includes large and midcap securities of the U.S. equity markets. The index is designed to reflect the performance of an investment strategy that, by tilting away from free-float market-cap weights, seeks to gain exposure to those companies demonstrating a robust ESG profile as well as a positive trend in improving that profile, using minimal exclusions from the MSCI USA index.

We can compare the performance of these three indices with that of the CRSP U.S. Total Market Index. All data is through February 2019.

In each of the three cases, we see that the ESG indices provided lower returns, and lower risk-adjusted returns, than the broad market index.

Conclusion

While ESG investing continues to gain in popularity, economic theory suggests that if a large enough proportion of investors chooses to avoid the stocks of companies with low ESG ratings, the share prices of such companies will be depressed. They will have a higher cost of capital because they will trade at a lower price-to-earnings ratio.

Thus, they would offer higher expected returns (which some investors may view as compensation for the emotional “cost” of exposure to what they consider offensive companies). Academic research I reviewed in a recent article has confirmed the evidence supports the theory.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.