ESG: Weight of evidence
There is no consensus on a positive link between ESG and improved portfolio performance
- There is no consensus on the relationship between ESG and investment performance
- There are three types of methodologies that use ESG data: value-based exclusions, impact screens, and ESG ratings
- Empirical research provides evidence of a risk-reducing effect when ESG ratings are used in portfolio construction
Over 2,000 research articles from academics and financial professionals have analysed the link between companies’ environmental, social and governance-related (ESG) characteristics and their financial risk and performance.
While one study found that there is little research concluding that using ESG criteria has impaired investment performance, there is also no consensus on whether ESG has improved risk-adjusted returns.
Why the lack of consensus? Many of the ESG investing methodologies used in studies were designed to meet social or ethical values rather than financial objectives. To understand the link between companies’ ESG characteristics and their financial risk and performance, it is important to evaluate only the studies that use ESG methodologies specifically designed to identify financially relevant issues
There are three types of methodologies that use ESG data. Only the last of these is focused on financial performance, and, even then, not all the latter are based on an economic rationale:
• Values-based exclusions: Typically, portfolios screen out companies involved in certain business activities, such as the production and distribution of alcohol, tobacco or weapons. These screens, which dominated ESG investing in the 1990s, aim to align portfolios with investors’ individual values or preferences and are often referred to as socially responsible investing (SRI), or ethical investing.
• Impact screens: While values-based screens aim to reduce exposure to companies that impose costs on society at large (known as negative externalities), impact screens aim to identify companies that can drive positive social change — for example, companies in clean technologies. Impact portfolios are typically fairly concentrated and can have strong active factor exposures and significant exposures to individual stocks that may not relate to their impact theme.
• ESG ratings: While values-based screens and positive impact screens focus on what type of products and services companies produce, ESG ratings typically focus on how ESG risks and opportunities are incorporated into a company’s business model. This analysis is typically based on a broad range of E-, S- and G-related indicators, such as carbon footprint, water usage, data security, human-capital development, executive pay and board structure. Within ESG ratings methodologies, there are two key approaches – one that relates to the rater’s subjective standards on what constitutes ‘good’ ESG, using a scorecard where the weights represent preferences, and one that focuses on capturing financial relevancy through a financial model-based ESG ratings based on an economic rationale, such as how each ESG risk indicator may impact future earnings or the asset of a company1 .
There are two other reasons why there is a lack of consensus on as to whether ESG criteria have resulted in improved returns.
• Lack of a holistic approach: Some researchers have searched for an ESG factor premium and neglected other potentially stronger economic transmission channels, such as the identification of company-specific risks. One study emphasised the need for a holistic approach by analysing the impact of ESG ratings on a variety of risk and performance indicators following different systematic and stock-specific transmission channels, explaining how ESG characteristics led to a financial impact (see figure 1).
• Lack of causality: Some researchers – including at MSCI – have performed backtests or correlation studies, which typically depended on a given timeframe and investment universe. Such research could not provide evidence for a causal relationship between ESG ratings and performance. In contrast, another study emphasised the need to test ESG ratings within an economic model that allows for an assessment of causality.
A fuller picture
For most institutional investors, obtaining financial benefits from their ESG investments is a key motivation. Research can be categorised as follows:
• Economic transmission: The type of economic transmission, which can either be idiosyncratic (company-specific) or systematic (affecting a group of companies in a similar way);
• Financial objectives: These can be related to either risk or performance.
For each of these categories, there is evidence that ESG ratings have been associated with a financial effect. Most research, however, focuses on just one or two of these aspects. To see a fuller picture, we seek to provide a consolidated overview across all four categories, based on MSCI research (figure 2). Darker shades indicate increasing levels of confidence in the economic arguments and statistical results.
Data history has important implications for our findings. In general, historical data series for ESG ratings applied to a global universe were much shorter (for example, MSCI ESG Ratings have fully covered the universe of MSCI World index companies since 2007) and of lower frequency (typically annually) compared to other areas of finance – for example, credit ratings or equity factors – making it challenging for researchers to achieve similar confidence levels. We get more robust results from analysing idiosyncratic transmission channels, which offer several thousand ESG company ratings per year, compared with systematic transmission channels with a limited time history and which are likely to offer lower levels of statistical confidence.
We are seeking coherence between economic arguments and their statistical confidence in the data. The economic and empirical evidence for each of the four financial categories:
• Idiosyncratic risk: Companies we analysed with high MSCI ESG Ratings have historically shown lower financial-drawdown frequencies, while controlling for other factors. While ESG research cannot predict future incidents, ESG ratings provided an indicator that corresponded with significant differences in the frequency of these incidents happening during the respective study periods. These results are intuitive, as companies with high ESG ratings were considered to have had a greater ability to manage and mitigate company-specific risks than lower-ranked sector peers;
• Systematic risk: Many of the companies with high MSCI ESG ratings we examined historically showed lower levels of systematic risk than companies with poor ESG ratings. The economic rationale is again intuitive. Companies with strong ESG characteristics were more resilient when faced with changing market environments, such as fluctuations in financial markets and changes in regulation;
• Idiosyncratic performance: Companies within the MSCI index that had high ESG ratings were more profitable and paid higher dividend yields, while controlling for other factors – that is size, industry and region – from May 2007 through November 2017;
• Systematic performance: It is not clear, however, whether ESG can be considered a new factor that has earned a premium over time. Several researchers have observed that companies with high MSCI ESG ratings outperformed those with low ratings. They also uncovered clear regional differences. Evidence for ESG characteristics having a positive impact on stock performance was strongest in the emerging markets and Europe, but weaker in the US. However, some of the positive performance results may have been the result of exposures to other equity factors.
In short, empirical research provided evidence of a risk-reducing effect when ESG ratings are used in portfolio construction. Statistical confidence levels were higher for idiosyncratic risks due to the larger relative sample size that was used.
1 Eccles and Strohle (2018) explore the historical origins and recent evolution of various ESG scoring and rating approaches, highlighting a distinction between value-driven and values-driven approaches. A common library of ESG data and metrics can be used to reflect either normative preferences (such as scoring companies on contravention of different global norms or involvement in controversial business lines or practices) or financially driven considerations.
Guido Giese is executive director, applied equity research and Linda-Eling Lee is global head of ESG Research at MSCI