While institutional investors have been showing increasing interest in ESG companies over the years, it makes sense to believe that they’re less profitable. After all, one would assume that avoiding negative externalities would necessitate additional non-operational costs.
However, a paper titled “Can ESG Add Alpha?”
from investment research firm MSCI finds that it is possible to have ESG-oriented strategies that outperform global benchmarks over time.
The study started with the construction of two ESG-oriented model portfolios. The first, which was built from an “ESG Tilt” strategy, selects for stocks that perform remarkably based on specially developed MSCI ESG ratings. The second model, which was created using an “ESG Momentum” strategy, favors stocks that have improved their ESG ratings over recent time periods.
Both model portfolios’ historical performance was individually compared with that of a global benchmark portfolio, the MSCI World Index, over a period of 7-8 years ending in February 2015. The analysis showed both strategies outperforming the global index.
“The Momentum strategy performed consistently well through the sample period, while the Tilt strategy saw roughly two-thirds of its outperformance come in the last two years of the eight-year sample period,” the paper reports.
After teasing apart the possible sources of the outperformance, the study found that “a significant portion came from stock-specific sources which could indirectly be attributed to the ESG signals”.
There are several possible explanations for increases in performance related to ESG scores. Companies that focus on ESG avoid costs arising from ESG issues, such as labor disputes and environmental fines. They can also take advantage of benefits brought by ESG-related opportunities, such as clean technologies. Companies with improving ESG scores also tend to enjoy increased valuations from market participants who see their potential ability to avoid risks from ESG-related violations.
“These backtested model portfolios show an example of how institutional investors with the tolerance to take some active risk, while at the same time looking to improve the ESG profile of their portfolios on a systematic basis, could incorporate such strategies in their investment processes,” the paper concludes.
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