A summary of some of the public industry research examining the connections between ESG factors, company profitability and investment returns.

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By Michal Bartek, Senior Lead, Guidance, PRI Responsible Investment Solutions

Since our January 2023 review of industry research on the connection between ESG factors and portfolio returns, much has changed. The responsible investment industry has been under siege in certain regions, particularly the US, where the backlash against ESG has intensified and fund outflows have increased.

This piece is our third blog summarising some of the public industry research examining the connections between ESG factors, company profitability and investment returns. It is certainly an opportune time to revisit the evidence. (Previous blogs appeared in 2021 and 2023. In addition, links to relevant academic papers are available through blog posts in our research hub.)

Energy sector a driving force since 2022

Industry and academic research typically showed strong market-relative and absolute performance from sustainable and ESG strategies in the decade prior to February 2022. That changed with the tragic events in Ukraine. Since then, the broad narrative is that rising oil prices and strong performance from defence stocks dented relative and absolute performance of responsible investment strategies. Not investing in, or being underweight, these sectors have contributed to a more difficult environment for responsible investors to outperform benchmarks. However pieces from Kroll and MSCI offer a more nuanced message – both noting that companies with higher ESG ratings have outperformed sector peers.^[1]

Another factor in the debate around the performance of ESG strategies over the last decade has been crowding. Has relative outperformance from highly rated ESG stocks been driven by strong fund inflows, limited liquidity and investors driven by ESG rankings rather than earnings or cash flow fundamentals? Has it simply been a case of expansion of valuation multiples beyond what current and future earnings could justify? This would not bode well for future relative performance.

MSCI’s research shows that, while outperformance may arise from multiple expansion in some cases, the main driver is better earnings fundamentals. McKinsey’s research^[2] supports MSCI’s conclusions and also finds that management teams that chase growth without considering how their strategies could impact people, planet and their firm’s long-term sustainability not only increase reputational risk but are also less likely to lead to full growth potential. At the other end of the ESG-vs-performance spectrum is a study^[3] by Vanguard finding little or no relationship, although the stock universe was narrower in geographic scope compared to the more global ones used in other papers.

MSCI’s research shows that, while outperformance may arise from multiple expansion in some cases, the main driver is better earnings fundamentals.

Whereas most of the earlier research focused on the connection between ESG factors and returns, a number of recent industry reviews^[4] of academic work have looked at a variety of factors relating to ESG and performance. Rockefeller Asset Management (among other conclusions) points out that improved corporate performance due to ESG factors becomes more marked over a longer time horizon, that ESG integration seems to perform better than negative screening approaches and that integration of ESG factors in asset selection and portfolio construction can provide downside protection and lower volatility. Abrdn confirms the latter point while noting the positive implications of higher ESG scores for the cost of capital, including in emerging markets countries.^[5] Robeco’s particularly detailed meta analysis^[6] also points out that many studies failed to distinguish between the different preferences of sustainable investors. Some investors may be seeking alignment of their investments with their values while others prioritise financial returns, resulting in a variety of objectives and investment mandates. This can skew financial returns of the broader universe of responsible investors who integrate material ESG factors.

A caution regarding correlations

In earlier blogs we noted that any links between ESG and performance are nuanced and complicated. As the industry papers^[7] repeatedly note, correlations are influenced and complicated by:

geography
market capitalisation
industry sector
relative and absolute rankings
ranking methodology changes
incomplete coverage of the investment universe
historical data limitations
varying government policies and incentives that impact company performance
shifting consumer behaviours

It is all too easy to conclude that constructing portfolios from the best ESG-rated companies is the holy grail of investing. But investors should bear in mind:

the list of complications above;
the fact that style trends (such as quality) can overlap with ESG factors;
that thorough research, analysis and stewardship should not be overlooked.

Conclusions

Our review barely touches the surface of the research and analysis being published. The volatile market environment of the last two years has again stress-tested the relationship between returns and ESG factors. While the broad conclusions about relationships between ESG attributes and corporate performance remain valid, researchers are looking more closely at what we mean by ESG investing and ESG scores and assessments. The table below lists some of the key pieces referenced in this blog.

We welcome comments and suggestions of any relevant research we have missed.

Selected industry papers

These papers are intended to provide a breadth of views and analysis from the investment industry.

Title	Author	Short description
ESG Ratings in Global Equity Markets: A Long-Term Performance Review	MSCI Research	Examines performance of ESG-rated companies in developed markets over 17 years and emerging markets over 11 years ending Dec 2023. Found that top-rated companies have consistently outperformed their lower-rated peers. Driven chiefly by better earnings fundamentals rather than valuation expansion.
ESG and Global Investor Returns Study	Kroll	Examined relationship between historical returns and ESG ratings of over 13,000 publicly traded companies from 2013-2021. Found that companies with better ESG ratings generally outperformed those with lower ratings.
Achieving sustainable profitable growth with ESG	McKinsey & Company	Examined performance metrics for the 10,000 largest global companies spanning 2016-22. Found that companies that pursue stronger growth and profitability while improving ESG performance deliver superior shareholder returns.
Is there a link between ESG ratings and investment returns?	Vanguard	A study of ESG ratings vs stock price returns using Russell 3000 universe. Found very little link at stock and portfolio level and high sensitivity to time periods considered. Noted style factors as explanatory drivers.
ESG and Financial Performance	Rockefeller Capital Management	Meta-study of academic papers published between 2015 and 2020, splitting them into those focused on corporate performance vs those with a focus on investment performance. Found a positive relationship with ESG factors in most studies in both groups and concluded that: improved financial performance due to ESG becomes more marked over a longer time horizon; ESG Integration as a strategy seems to perform better than negative screening approaches and ESG ratings momentum may cause improvers to outperform leaders; ESG investing appears to provide downside protection, especially during social or economic crises; sustainability initiatives at corporations appear to drive financial performance due to factors such as improved risk management and innovation; managing for a low-carbon future improves financial performance; ESG disclosure on its own does not drive financial performance.
How ESG can enhance portfolios — the evidence	Abrdn	A meta study of peer-reviewed academic research concludes that: ESG principles can benefit single-stock returns, with shares of better-quality companies able to perform better than inferior peers and benefit portfolio risk and return. ESG integration can lead to lower risk. Evidence shows that ESG analysis can help deliver a similar return while reducing investment risk.
Investing the link between ESG and investment performance	Robeco	Meta study of academic research mainly ending before 2023 that finds a positive link between ESG factors and company financials, while the link with overall portfolio returns is less robust. Some investors prioritise aligning investments with personal ideologies and normative value systems over pure financial returns. This can affect the performance of ESG-focused investment portfolios.
ESG & investment performance: think strategically Based on ESG and investment performance: challenges ahead? CIO Special report	Deutsche Bank	This article highlights a number of difficulties in assessing the performance of high-ESG scoring companies, noting that ESG investment ratings vary between rating agencies and have also changed over time. Argues that companies with strategies to address ESG issues are likely, in general, to prove better at navigating an increasingly complex environmental and regulatory environment.
Sustainability and portfolio returns	JP Morgan Asset Management	A blog on issues that arise when trying to measure the relationship between ESG and returns. Points out difficulties in measuring correlations between ESG characteristics and returns due to differing methodologies of data providers, incomplete data coverage and metrics and methodologies that change over time. Also notes that excluding a sector (as opposed to tilting holdings towards higher ESG scores) complicates measurement due to factor rotations, market preference for particular styles.

The PRI blog aims to contribute to the debate around topical responsible investment issues. It should not be construed as advice, nor relied upon. The blog is written by PRI staff members and occasionally guest contributors. Blog authors write in their individual capacity – posts do not necessarily represent a PRI view. The inclusion of examples or case studies does not constitute an endorsement by PRI Association or PRI signatories.