Can responsible investing deliver ESG benefits and financial returns at the same time? We believe it can. And there is also a significant weight of evidence to support this premise. In this article we look briefly at three academic studies and two NN Investment Partner research collaborations on this topic and summarise the most important objectives and findings. The results underscore our conviction that integrating environmental, social and governance (ESG) criteria and engagement into the investment process helps improve risk-adjusted returns.
1) Companies that do well on ESG criteria on average generate better results
ESG and Financial Performance: Aggregated Evidence from More than 2000 Empirical Studies
Gunnar Friede (Deutsche Asset & Wealth Management), Timo Busch (University of Hamburg) & Alexander Bassen (University of Hamburg, University of Reading) 2015
Between the early 1970s and 2014, around 2,200 academic studies were carried out that investigated the relationship between ESG and corporate financial performance. As the results were often contradictory, unclear or conflicting, Friede, Busch and Bassen decided to aggregate the results of these studies. Their metastudy, published in 2015, gave compelling evidence that companies that do well on ESG criteria generate better financial results.
The main conclusions:
- 63% of the 2,200 studies carried out between 1970 and 2014 revealed a positive relationship between corporate ESG scores and financial performance
- Since the mid-1990s this relationship has been relatively stable
- The positive relationship is weakest for the social factor and strongest for the governance factor, the “S” and the “G” of ESG, respectively
2) ESG leads to low and stable spreads for corporate bonds
Evaluating the Relationship Between ESG and Corporate Fixed Income
Breckinridge Capital Advisor and MIT Sloan School of Management (2016)
The most important conclusion of this 2016 study is that higher corporate ESG scores are compatible with narrower and more stable spreads in the corporate bond market. The spread between bonds issued by companies with the lowest and highest ESG scores is, on average, almost 200 basis points.
However, the researchers also made several observations regarding their study. An ESG score is derived from information provided by the company itself. So companies that publish information have a better chance of scoring higher on sustainability, irrespective of the results of their sustainable activities. Investors in companies with high ESG scores also seem to benefit from risk protection in falling markets. This could indicate that ESG is regarded as a measurement of quality.
The main conclusions:
- Good ESG scores have a positive and consistent relationship with narrow, stable spreads
- This relationship strengthens when markets are under pressure, and continues when they recover
- Strong intuitive relationship between ESG scores and core figures that express financial health, such as debt ratios and/or profitability
3) Engagement leads to higher returns
Elroy Dimson, Oğuzkhan Karakas, Xi Li (2015)
This study from 2015 examined the results of 2,152 engagement dialogues, carried out by an anonymous asset manager with 613 US companies over a ten-year period. Engagement is a process that requires a long-term mindset. The chance that a company will adapt its behaviour after engagement is 18% and two or three attempts lasting between one and one and a half years are needed to achieve success. Successful ESG activism leads to positive, cumulative returns of 7.1% in the following year.
The companies in question score better on many fronts, such as operational performance, profitability, efficiency and stock volatility. The positive market response to successful engagement is most significant for corporate governance (+8.6%) and climate change (+10.3%). If the engagement does not bear fruit, the improvement in returns diminishes again.
In an update last year, the researchers wrote that there is more chance of an engagement being successful if it is carried out by a large shareholder from the same region or if the party carrying out the engagement has significant assets under management.
The main conclusions:
- Engagement is more likely to succeed if a company has concerns about its own reputation, and there is room for improvement
- Corporate results and company management improve as a result of successful engagement, especially on environmental and social issues
4) ESG momentum is good for investment results
In 2016, NN Investment Partners started a collaboration with the European Centre for Corporate Engagement (ECCE) of the University of Maastricht to study the relationship between corporate sustainability scores and financial returns. In order to do this a dataset of over 3,000 developed market companies was analysed between 2010 and 2014. One of the main findings was that absolute ESG scores are not necessarily a good indication of future corporate performance and that focusing on incremental changes or momentum can also enhance returns. A portfolio of stocks with medium ESG scores (high ESG momentum) generates a more attractive Sharpe ratio (a risk-return metric) than one with high or low ESG scores (low ESG momentum).
The main conclusions:
- In most cases portfolios of stocks with high ESG scores performed less well that those with lower scores
- A portfolio of stocks that scored well on ESG momentum performed better than the those with lower momentum scores. The governance factor, in particular, was what made the difference
- Excluding controversial companies is a relatively simple way of improving the risk-reward characteristics of portfolios
Sharpe ratios of stock portfolios with low (L1), average (L2) or high (L3) ESG scores
Source: NN Investment Partners and ECCE
5) New research on the way: ‘Delivering value to investors from sustainability’
NN Investment Partners has set up an additional new partnership with Yale University via the Yale Initiative on Sustainable Finance (YISF). This new research stream explores whether and how the integration of ESG aspects in the investment process may improve the risk-return profile of investment portfolios.
YISF’s aim is to produce fresh thinking and cutting-edge research on the challenges and opportunities of integrating sustainability insights into investment decisions. The results of this research programme aim to support NN IP and the broader investment community in developing tools to help their clients achieve both financial and sustainable goals.
Putting the evidence into practice
The research examples above all demonstrate the link between the longer-term positive impact of ESG integration and engagement on risk-adjusted returns. ESG is embedded into the investment process for the majority of NN IP’s strategies. And we also offer two specific product ranges with an even stronger focus on ESG. Our sustainable strategies incorporate a clear tilt towards sustainability opportunities, while our impact products target companies that make a clear positive contribution to the UN SDGs. This enables investors to choose the level of ESG exposure they wish to obtain across a broad range of asset classes, according to their investment requirements. And to benefit from attractive risk-adjusted returns while making a contribution to society at large.
Jeroen Bos, Head Of Equity Specialties NN Investment Partners