In the ongoing debate over ESG investing, detractors and supporters have clashed over one key issue: would limiting a portfolio to companies that show good conduct and values hamper its returns over time?
To critics, excluding companies that score low on ESG means potentially leaving out some reliable performers from the fossil-fuel industry, alcoholic drink producers, and tobacco firms, to name a few. To flag-bearers of responsible investing, a portfolio of companies that score high on ESG metrics has a greater chance of doing well in the long run as they sidestep reputational and regulatory pitfalls.
In an effort to answer the question, Gautam Dhingra, CFA and Christopher J. Olson, CFA, both from High Pointe Capital Management, did an analysis of S&P 500 companies based on figures from Refinitiv’s ESG database. Refinitiv generates ESG scores for each firm based on 178 data points, with each company ranked on a 100-point scale relative to its peers. Companies are given a composite ESG score as well as separate category scores for Environmental, Social, and Governance.
The two divided all the S&P 500 companies into four categories based on their historical ESG ratings from January 2008 to December 2018: “Excellent,” which includes those with scores of at least 76; “Good” for those that scored between 51 and 75; “Fair” for companies that scored between 26 and 50; and “Poor” for the ones that scored 25 at most.
“The trend is clear: S&P 500 companies have improved their ESG metrics over time,” the two wrote in a piece published by the CFA Institute. The improvement, they reasoned, probably came as companies realized the importance of such scores.
They then looked at how a portfolio of high-scoring ESG companies that core above the median compare against a low ESG portfolio composed of their lower-scoring peers. “We built these portfolios on a monthly basis, from January 2008 to December 2018, using the ESG score of the companies,” they wrote, adding that they measured each portfolio’s returns over the next month.
Based on the respective geometric means of their annualized returns, the High ESG Portfolio bested the Low ESG Portfolio by 16 basis points (7.34% vs 7.18%). But looking at the arithmetic means shows the High ESG Portfolio underperforming its lower-scoring counterpart (8.23% vs. 8.32%).
The contradiction, they said, could be explained by the difference in portfolio volatility: the High ESG Portfolio’s returns had an annualized standard deviation of 14.91%, as compared to 16.38% for the Low ESG Portfolio.
The lower volatility in the High ESG Portfolio, they also found, was correlated with the Quality factor, as there was a 0.41 correlation between the factor and the added value added by the High ESG Portfolio over the other portfolio.
“Over the long run, the cumulative performance of the two ESG portfolios is quite similar,” they added, noting that the High ESG Portfolio’s investable universe was 26% smaller as measured by market capitalization due to the above-median ESG score requirement. “So, at a practical level, the theory that shrinking the selection of potential stocks based on ESG criteria will lead to lower returns is not supported by the historical data.”
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