Companies with strong records on Environmental, Social and Governance (ESG) criteria may deserve credit as good corporate citizens, but does investing in them over companies with weak ESG records raise the risk of sacrificing potential returns?
According to a growing pile of research, it does not. Rather, incorporating ESG factors into an investment strategy can potentially improve performance by identifying companies with weak governance or a higher risk of environmental or social issues that can impact value, says Judy Cotte, Managing Director—Head of ESG at Onex. Similarly, companies with strong ESG-related practices may have a competitive advantage.
“There’s a misconception that considering ESG factors requires you to forgo a financial return. But the research at this point is pretty clear that ESG integration does not negatively impact your return,” she said.
This would seem to fly in the face of the thinking that putting any limitations on investing will necessarily result in weaker performance. But applying principles to define an investment universe has long been a practice of successful investors. ESG acts as an additional layer of due diligence that can help find flaws in a company that a traditional analysis might miss, says Alkarim Jiwa, Managing Director, Head of Canadian Equity at Gluskin Sheff, Onex’s wealth management partner.
Onex and Gluskin use an ESG integration approach to Responsible Investment (RI). This approach involves evaluating ESG factors for each company to assess financial risks and opportunities and incorporating them into investment decisions. This contrasts with other RI approaches that emphasize screening out certain sectors to allow investors to align their investments with their values or focusing exclusively on certain sectors to align investments with certain environmental or social themes.
“We’re not using it for screening purposes,” said Jiwa.
It’s more about fine-tuning how to define which companies are doing well on their metrics, and it improves our investment process itself, which should generate better returns for clients over the long term.
With an increased focus in the market on ESG over the last decade, there has been a corresponding effort to quantify the long-term performance impact of an ESG approach for a company or fund. Gauging performance can be challenging due to differing approaches to both evaluating corporate ESG efforts and incorporating ESG into investment strategies. However, a growing number of studies point to benefits of an ESG integrated investment approach.
One recent study by Morningstar Research looked at 4,900 European, U.S. and global funds over the ten years ending in 2019. It found that 58.8% of ESG-focused funds that existed across the entire ten years outperformed their average traditional peer during the same time period.
Another study—a meta-analysis released last year by the NYU Stern Center for Sustainable business and Rockefeller Asset Management—gathered data from 1,141 peer-reviewed papers and a series of meta-reviews covering 1,400 underlying studies published between 2015 and 2020. The analysis separated out the underlying studies that focused on corporate financial performance from those focused on investment fund performance. It found a positive relationship between ESG and financial performance in 58% of the studies that focused on corporate financial performance metrics, while only 8% showed a negative impact. For studies covering investment funds, it found 59% showed a positive correlation and 14% a negative correlation.
From the results, researchers concluded that improved financial performance due to ESG becomes more noticeable over longer time horizons, and that ESG integration as an investment strategy generally performs better than approaches that simply screen out certain sectors.
While the rise and visibility of ESG practices have been driven in part by increasing concern among investors over climate change, social justice and other issues, Jiwa says his decision to adopt an ESG investment framework in Gluskin’s Canadian equity strategies two years ago was driven chiefly by a desire to add additional criteria to help identify quality companies.
“For us, the initial idea was to improve our process and thinking. We fine-tuned how we thought about what makes a good-quality company, and it was also a process for ranking all of our companies to categorize them and then see their progress over time,” he said.
This means thinking about ESG issues in the context of a specific industry and also how individual E, S & G factors intersect. “For example, it is important to consider an oil and gas company’s carbon emissions and its efforts to reduce them in comparison to their industry peers. However, it is also important to evaluate how well they are treating their employees and whether they have a low occurrence of accidents. Those factors all go into making a good company,” said Jiwa.
I’ve generally found that companies that are better corporate citizens tend to do well over the long term.
“If they’re not good corporate citizens, usually they’ll have a mishap at some point in time, which could have a significant financial impact.”
For Jiwa, a lot of this boils down to corporate governance, the ‘G’ in ESG. Does the company have a good corporate governance structure, such that the management team is competent and trustworthy and there is a quality board of directors providing appropriate strategic oversight? Is it a high-quality business that is delivering returns that are sustainable?
With the COVID-19 pandemic dominating headlines over the past two years, one could be forgiven for thinking ESG issues might become a secondary concern for many investors. However, a recent study found that the pandemic has been a catalyst for many investors to pay more attention to how ESG factors are integrated into corporate strategy. The 2021 EY survey of global institutional investors found that 74% of respondents said they are now more likely to sell a company based on poor ESG performance than before the pandemic, and 90% said they now attach greater importance to a company’s ESG performance when making investment decisions.
“Ultimately, integrating ESG into your investment process is just one part of a thoughtful investment approach. It requires investors consider broader ESG factors that may not initially show up in financial statements, but which can ultimately have a significant impact on a company’s value,” said Cotte.