I’ve talked about what Environmental, Social and Governance (ESG) investing is, how to build portfolios with ESG factors, and how companies are rated. Now let’s talk about how ESG investing affects investment performance.
Is ESG good for your portfolio?
When ESG investing began, early research focused on the so-called ‘sin stocks’ of oil, tobacco and gaming. A 2007 paper by Hong & Kacperczyk1 (H&K) found that these sin stocks significantly outperformed their benchmarks by an annual margin of about 3%. These results were explained by the neglected stocks argument: because these stocks are avoided by public and institutional investors, they come at a discount (about 20% in their study), and investors therefore capture an excess return by investing in these industries. A 2008 paper by Fabozzi, Ma & Oliphant2 supported this argument and even found that socially responsible companies had extra expenses due to operating green infrastructures and were therefore less profitable.
The sin stock premium fallacy
These findings obviously had an effect on the early days of ESG investing. There was this idea that ESG investing meant giving up higher portfolio returns.
Then in 2013-2014, this classically held view was challenged. There was an increased demand for Socially Responsible Investments and integrating ESG approaches became more prevalent in the investment universe, demanding more research on the topic. In 2015, Adamsson and Hoepner3 came out with a paper that questioned the methodology and results of the 2007 paper. They uncovered biases in the H&K research data that, once corrected, invalidated their conclusions. Fabozzi has more recently come out to acknowledge the same bias in his research paper from 2008.
It is that easy being green
Further research in 2015 by Khan, Serafeim and Yoon4 (K&al) into the impact of ESG investing found several things:
- A well-diversified ESG strategy had no significant impact on the risk or return of a portfolio.
- The way ESG information was published had created ‘noise’ that may have affected previous research conclusions.
- K&al also concluded that a better ESG classification may lead to better financial performance.
The Organisation for Economic Co-operation and Development (OECD) supported this, suggesting that the benefits of engaging in material sustainable practices are three-fold: better financial performance, business excellence and better stakeholder relationships.
For more depth on this issue, you should read our recent white-paper: A Guide to Responsible Investing. After reading all the above research, my take-away is that at the very least, ESG investing won’t hurt your portfolio returns over the long run. If these considerations are important to you, then let’s talk about the best ways to move your portfolio in the right direction.
1 Kacperczyk, Marcin T. and Harrison G. Hong, “The Price of Sin: The Effects of Social Norms on Markets.” SSRN Electronic Journal, 2006, doi:10.2139/ssrn.766465.
2 Fabozzi, Frank J. et al., “Sin Stock Returns.” The Journal of Portfolio Management, vol. 35, no. 1, 2008, pp. 82–94., doi:10.3905/jpm.2008.35.1.82.
3 Adamsson, Hampus and Andreas G. F. Hoepner, “The Price of Sin Aversion: Ivory Tower Illusion or Real Investable Alpha?” SSRN Electronic Journal, 2015, doi:10.2139/ssrn.2659098.
4 Khan, Mozaffar et al., “Corporate Sustainability: First Evidence on Materiality.” SSRN Electronic Journal, 2015, doi:10.2139/ssrn.2575912.