Think - AT LONDON BUSINESS SCHOOL

Does investing for good make for good investing?

ESG investing: a trade-off between principles and profits?

Investing for good 1140x346

Investors want to be good at allocating their money.  They want to make the smartest choices; they aim to make the best possible returns balanced against the risks they are taking.  This is simply good investing.

But good investing is not the same as investing for good.  More investors are concerned these days not just about getting the best financial returns.  They are increasingly looking to use their financial power to meet other aims.  They are concerned about the environmental impact of the businesses in which they put their money. 

They want to know about company performance in terms of emissions, pollution and waste. They want reassurance that investee companies are striving to meet social aims such as dealing fairly with employees and keeping them safe: this can extend to areas such as product liability and diversity.  And they want to know that governance standards are up to scratch: how soundly is a business being run?

Increasing numbers of investors are concerned to deploy their money in a way that helps meet these environmental, social and governance or ESG aims.  They want to be responsible.  As well as being good investors, they want to be investors for good.

Fund managers have had to respond to this demand. By 2018, an estimated USD $31 trillion (£25 trillion) of funds worldwide said they were taking ESG into account in choosing how to allocate money.  By early 2020, this figure was probably nearer USD $40 trillion.

But just how can investors pursue their ESG aims?  And does this hurt the returns they achieve?  Put another way, does investing for good mean compromising the aim of being a good investor? Do ESG investors have to sacrifice returns as the price for their principles?

"Investors can achieve market-beating returns by putting money into non-sin stocks that have exposure to the same factors that drive sin stock returns"

These questions are at the heart of new research published in the 2020 edition of the Credit Suisse Global Investment Returns Yearbook*.

The first issue is simply this: how might a fund position itself in order to claim that it has taken ESG considerations into account when choosing how to allocate its money?

The wages of sin

The most common ESG investment approach is to exclude so-called “sin stocks”, such as companies involved in gambling, tobacco or pornography.  But where to draw the line on what is sinful? Some investors may want to stay clear of arms manufacturers.  Others may feel that any company whose fortunes are built on the production of fossil fuels ought to be excluded. Should alcohol be out of bounds? Definitions of sin are fluid.

Nevertheless, looking at an obvious category of sin stocks – tobacco – gives food for thought. Over the very long term, tobacco companies have been an excellent investment. In the US, tobacco has been the best-performing sector over the years 1900 to 2019. Going back as far as 1900 is impossible with alcohol because of prohibition in the 1920s. But since prohibition was lifted, alcohol has been the second-best performing sector of the US stock market.  In Britain, the picture is similar: in the periods for which data is available, tobacco and alcohol have been the top two performing sectors for investors.

This is triumph of the sin stocks. What might explain it?

Here is one possibility. If enough investors shun a stock, that should depress its share price.  A lower share price means investors are buying an income stream on the cheap. And that in turn means that the company offers a higher expected return for each dollar or pound invested in the company’s equity. That’s good news for less squeamish investors who are prepared to buy the shares. They benefit from the downward price pressure imposed by the investors who steer clear.

Alternatively, it may be that industries such as tobacco and gambling have suffered less from litigation and regulation than some investors feared.  These industries have escaped more lightly than the market expected.

But also, it is possible that sin stocks simply have characteristics that would be advantageous for any company, be it appallingly sinful or commendably virtuous.  For example, companies classed as sin stocks are relatively recession-proof and there are high barriers to entry, which keeps returns buoyant. 

People still drink and smoke even when times are tough.

Does it follow from all this that ESG-conscious investors are inevitably going to dent the performance of their portfolio by excluding sin industries – industries whose past investment performance has been strong?

"A company might be able to scour the findings of a range of organisations that give ESG ratings, and choose for its annual report the one that paints it in the most flattering light"

A study by Blitz and Fabozzi** suggests that in fact, sin stocks outperform because they have characteristics that are often seen in stocks of any type that have done well. Don’t simply compare sin stocks with the market as a whole. Compare them with other companies of similar size, stock price volatility and momentum; add in value (comparing share prices with book values), profitability and investment discipline. Once all these factors have been taken into account, sin stocks’ apparent ability to outperform vanishes.

This is crucial for an investor who wants to avoid companies tainted by the sin label. Investors can achieve market-beating returns by putting money into non-sin stocks that have exposure to the same factors that drive sin stock returns, For example, they can select low risk, high-profitability companies that are financially disciplined in deciding how much to invest. All these selections can be made from the more virtuous, less-sinful segments of the market.

None of this is to bolster widely-circulated assertions that investing in virtuous companies will deliver superior returns – that investing for good will make for good (for which read profitable) investment.  It merely suggests that the returns of sin stocks can be matched by careful selection of non-sin companies that share their investment characteristics.

As mentioned above, ideas of sinfulness change over time: alcohol is seen as less sinful now than it was in 1920s America; the health effects of smoking tobacco weren’t widely appreciated until the 1950s.

But today, there are other, and much larger, sectors that some investors might choose to avoid.  The fossil-fuel sector is one; while Sharia funds may spurn investments in banking and insurance.

Would excluding a big sector from a portfolio have a substantial impact on overall returns of an investment portfolio?  The new Yearbook research indicates not.  Over the period 1926 to 2019, the effect on annualised portfolio performance of having permanently excluded a single sector, even a big one such as financials, manufacturing or energy, is tiny.

A broader approach

Simply excluding sectors seen to be distasteful is only one strategy available to investors seeking to be “responsible”.

The ESG-conscious investor can also take a more nuanced approach, looking at individual companies to see how they rate in terms of environmental, social and governance measures. There is now a plethora of organisations that will rate companies for their ESG performance. These include index companies such as MSCI and FTSE Russell and standalone rating providers such as Sustainalytics. ESG investors will often rely on these organisations’ assessments of companies in framing their decisions on where to put their money.

But there is a problem.  The different agencies often disagree on what companies score well on ESG and which score badly. Take Tesla as an example: in ESG terms is it a “good” or “bad” company in which to invest? MSCI rates it highly because of its cars’ low emissions.  Meanwhile, FTSE puts it at the bottom of the table of global car manufacturers because of its factory emissions.

This is reflected more broadly: the ESG scores given to individual companies diverge widely, depending on which agency is making the assessment. Take a further example. FTSE Russell maintains that Facebook has a poor record on environmental grounds; MSCI rates it very highly.

It is not that ESG raters are incompetent. They have to make judgements about what is important and what is not.  And they will differ in deciding what weightings to give to each element – the E, the S and the G – in settling on an overall score. When looking at insurance companies, for example, MSCI allocates a 74% weighting to social measures; for Sustainalytics, this element of the mix merits only 38%.

"Evidence suggests that active shareholder engagement with companies over ESG goals and objectives can have a beneficial financial effect"

CS-YEARBOOK-2020-768x400

The net effect of the divergence of approaches is that a company might be able to scour the findings of a range of organisations that give ESG ratings, and choose for its annual report the one that paints it in the most flattering light.

Getting in early 

By definition, good governance should lead to good corporate performance. But this is not the same as offering superior investment returns indefinitely.

Experience since the early 1990s illustrates this.  In that decade, investors began to examine standards of corporate governance more closely. And research suggested that in that period, companies that gave shareholders strong rights tended to show superior investment returns: their share prices did well.  But from 2000, the effect disappeared: after outperforming the market in the 1990s, a governance-based strategy failed to yield superior returns.

There is a possible explanation. It appears that from 2000, the good-governance firms continued to enjoy higher valuations.  But by this time, good governance was fully reflected in share prices. Learning the significance of good governance had given a fillip to well-run company stocks but once that effect had been fully reflected, their share prices would not continue to outperform.

What about environmental and social (E&S) factors? These are often seen as being at the heart of what is termed corporate social responsibility (CSR). There is a strong business case for spending in areas that could be said to fall under the E&S umbrella.  Aircraft manufacturers face huge costs if their products are unsafe; carmakers will be hit if they fiddle emissions tests; customers will not feel kindly towards a retailer that uses child labour.

But there is little sound evidence to show that, in terms of investment performance, companies with good CSR records are likely to beat those without. And such evidence that there is suggests a pattern similar to that seen regarding corporate governance.  Shares in companies highly rated for their CSR record outperformed between 1990 and 2001. But that effect soon dwindled. In the five-year period from 2007 to 2012, there was no discernible difference in returns between “good” and “bad” companies. 

As with governance, it seems investors absorbed the significance of E&S information; that was soon reflected in stock prices; and thereafter there was no financial benefit to be had.

Furthermore, funds that take an ESG stance perform virtually in line with the market: there is no significant financial advantage – or disadvantage, for that matter – to be had by putting money into an ESG fund.  Also, indices such as the FTSE4Good, which aims to track the performance of companies that demonstrate strong ESG practices, show no long-term market-beating advantage.

Making companies behave

Finally, there is a further route available to investors who want to take ESG factors into account when deciding how to allocate their money. They can actively engage with the companies in which they invest in order to promote responsible corporate behaviour. By the end of 2019, nearly 2,400 asset owners and asset managers had signed up to the United Nations-sponsored Principles for Responsible Investment (PRI). Controlling US$86 trillion in assets, they committed to following six principles.  

The first is to incorporate ESG issues into investment decisions. Crucially, the second is to be an active owner and to incorporate ESG factors into ownership policies and practices.

Evidence suggests that active shareholder engagement with companies over ESG goals and objectives can have a beneficial financial effect. Not all such shareholder interventions are successful. Indeed, a study published in 2015***, showed that fewer than one in five achieved the social or environmental goal they sought.  

But where the desired change was achieved, investment performance was given a significant boost. Unsuccessful engagements by shareholders led to no investment advantage.  But successful engagements led to an uplift in returns of 7.1% after one year. Subsequent research showed that an engagement with a company was more likely to succeed in achieving its objective where it was spearheaded by a lead investor with others working alongside it.

Investors – big ones, at least – can indeed make companies behave better.  And that is likely to deliver financial rewards. Furthermore, even the investor with only a modest sum to invest can be reassured: profit need not be sacrificed in the pursuit of principle. 

 

 

* The Global Investment Returns Yearbook 2020 is published by Credit Suisse Research Institute. The Yearbook is a 260-page hardcopy publication available from Credit Suisse or London Business School. Readers can download a 48-page Summary Edition free of charge from www.bit.ly/GIRY2020.


** Blitz and Fabozzi, 2017: Sin stocks revisited: resolving the sin stock anomaly, Journal of Portfolio Management 44(1); 105-111. Readers can download the entire article free of charge from www.bit.ly/Blitz-Fabozzi.


*** Dimson, Karakas and Li, 2015: Active Ownership.  Review of Financial Studies 28 (12); 3225-3268. Readers can download the entire article free of charge from www.bit.ly/ActiveOwnership.

 

Authors

Elroy Dimson is Chairman of the Centre for Endowment Asset Management at Cambridge Judge Business School and Emeritus Professor of Finance at London Business School.

Paul Marsh is Emeritus Professor of Finance at London Business School.

Mike Staunton is Director of the London Share Price Database, a research resource of London Business School.