A long-term strategy can help portfolios weather the inevitable ups and downs in the market. We believe sustainable investing–incorporating environmental, social and governance (ESG) insights into portfolios–is one such strategy, and can be implemented across most asset classes without giving up risk-adjusted returns over time.
Interest in sustainable investing is rising. The average S&P 500 firm cites ESG-related terms in earnings calls nearly twice as often as a decade ago, our text analysis of transcripts shows. Consumer staples, financials and health care lead the way. See the chart above. Meanwhile, regulation and investors’ desire to do good, mitigate risk or access niche market opportunities is stoking interest just as new benchmarks and products are making ESG investing more accessible across asset classes and regions. Total assets in ESG-dedicated mutual funds and exchange-traded funds in Europe and the U.S. grew nearly 50% from 2013 to 2017, according to Cerulli Associates. We find flows have picked up further in 2018. As more investors factor ESG considerations into their investment decision-making, there is good reason to believe the relationship between ESG and asset performance could further strengthen. We’ve found early evidence that a strong ESG focus may be linked to equity outperformance over time.
No sacrifice needed
We believe strong performance on ESG metrics can be a proxy for operational excellence: Companies and issuers that score highly tend to be more efficient in their resource usage—and more resilient to perils ranging from ethical lapses to climate risks. The quality bias in these entities suggests a focus on ESG may offer some cushion during market downturns. We looked at traditional equity benchmark indexes alongside MSCI’s ESG-focused derivatives. Annualized total returns of the ESG indexes since 2012 matched or slightly exceeded the standard index in both developed and emerging markets (EM), with comparable volatility, our study found. Early evidence also suggests that an ESG focus may offer the greatest rewards in EM, where issues such as shareholder protections, natural resources management and labor relations can be important performance differentiators.
In fixed income, credit investors typically need to sacrifice some yield to make their portfolios ESG-focused, since companies that score lowest on ESG metrics tend to carry the highest yields. Yet this tradeoff may be an illusion. Bonds with lower yields but higher ESG ratings have typically generated stronger risk-adjusted returns in the past decade, our analysis of the global high yield market found. We see ESG-friendly portfolios keeping pace with traditional portfolios over a full market cycle—even if they sacrifice a little yield during the most risk-on periods. A new suite of ESG-friendly EM debt indexes—jointly launched by JPMorgan and BlackRock—could help steer more capital into ESG leaders over time—and incentivize laggards to lift their game.
There are challenges
ESG data are still patchy, and are not equally relevant. To seek alpha via ESG strategies, investors need to go beyond headline ESG scores to understand how and why individual score components—such as climate risks, labor issues and shareholder rights—can affect returns. This can differ across regions, industries and companies.
We believe it is feasible to create sustainable portfolios that do not compromise return goals—and could potentially enhance risk-adjusted returns in the long run.