With spring in full swing and Earth Day last month, communities are starting to hold Earth Day activities to help people become more environmentally conscious as the snow melts away. These activities not only have a positive impact on the environment but also socially—who doesn’t enjoy a clean, green environment?
Environmental and social standards pertain to more than individuals and communities. Corporations have been doing their part as well, focusing on environmental, social, and corporate-governance (ESG) standards and capturing the attention of Wall Street.
With momentum driven by investors, Wall Street firms are critiquing companies based on their sustainability factors or ESG standards. There is a growing belief that environmentally conscious companies that manage their internal and external relationships well and maintain strong corporate governance will experience sustainable growth into the future.
ESG investing is a relatively young form of investment analytics, but it is growing. According to the leader in fund flows data, EPFR Global, since the beginning of 2013, ESG equity mutual funds worldwide have attracted net inflows of nearly $6.5 billion. $2.9 billion flowed into this asset class in 2014 alone.
Historically, ESG investing has been associated with equities. Recently that has changed as companies have started floating “green bonds” into the market. Asset flows into ESG fixed income mutual funds around the world are starting to pick up as well. We saw $302 million of net inflows into these funds during the first two months of 2016.
Some investors may feel morally compelled to invest in companies that follow the strict ESG guidelines, while others may consider ESG funds strictly on performance. Thanks to MSCI and MSCI ESG Research, financial advisors can provide information regarding the performance of ESG funds, and help their clients determine if sustainable investing really pays off or if a “returns at all cost” approach is more suitable for their client’s portfolios.
Below we provide some return and risk analytics to help financial advisors come to conclusions regarding ESG-style investing.Looking at the YTD, 1-year, 2-year, 3-year and 4-year annualized returns (Figure 1), the MSCI USA ESG index has underperformed its parent index, MSCI USA, by roughly one percentage point for all but the YTD time periods. The spread of underperformance widens when comparing MSCI USA ESG to the broad market, measured by the S&P 500 index.
Now, we would be remiss if we only looked at returns. One could surmise that investing in companies that follow ESG standards should reduce the risk of your portfolio, given that strong corporate governance is one of the three pillars. As you can see in the Risk/Return graph below (Figure 2), both the MSCI USA ESG index and the MSCI USA index are in close proximity to one another. The difference in the risk/return tradeoff among the three indexes looks to be inconsequential. So it’s tough to say if the ESG strategies are truly less risky.
Figure 3 provides more detail regarding the risk of the different indexes. The MSCI USA ESG index has a slightly lower standard deviation, while its sensitivity to movements in the S&P 500 Index (beta) is lower than that of the MSCI USA index. The smaller Sharpe Ratio also indicates that if you are looking for an investment that optimizes returns per level of risk, you are better off investing in the broad market. ESG investing offers only slightly less risk compared to the other two indexes.
Time will tell if companies that follow ESG standards do experience sustainable growth, but investing in these strategies comes down to more than just numbers. Investors who fund ESG strategies are voting for a clean environment with their wallets. Look around over the weeks before and after Earth Day to see which corporations are working to improve the environment, support charities, and help the less fortunate. Keep those companies in mind for clients who seek strategies that aim to do more than grow their portfolio and protect the environment.
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