Does ESG pay off financially?

PRI Chair Martin Skancke led a spirited discussion on one of the most commonly asked questions in ESG investing: What effect does responsible investing have on returns?

Speakers: Jean-Pascal Gond (Professor of Corporate Social Responsibility, Cass Business School, City University), Raghavendra Rau (Sir Evelyn de Rothschild Professor of Finance, Judge Business School, University of Cambridge), Michael Viehs (Visiting Research Associate at the Smith School of Enterprise and the Environment, University of Oxford, and Assistant Manager at Hermes Investment Management)

Michael Viehs said that companies with better ESG practices are more competitive as they are better prepared for external shocks, have reduced credit risk and often benefit from a lower cost of capital. He said that for investors, considering ESG factors can significantly reduce downside risk.

“Our results show, convincingly, that ESG pays off financially.”

Michael Viehs

To overcome the danger of positive ESG effects being priced in at a certain point but then fading, Viehs said that investors should pursue dynamic active ownership strategies rather than just rely on inclusion or exclusion strategies.

“Sustainability is dynamic because we know that morals, standards, values and investor preferences change, so investors can gain most by backing up their ESG integration strategy with corporate engagement strategies.”

Michael Viehs

Martin Skancke questioned whether investors, bidding up the price of companies when they learn they have superior ESG practices, means that the expected return drops, because investors are paying more for the same expected cash-flow. Viehs said that this wasn’t necessarily the case, because investors pursuing active ownership strategies might push up ESG standards even more, further boosting financial performance.

Skancke queried whether, as alpha is the difference between actual return and average market return and the sum of all those differences must therefore be zero, if every investor was a responsible investor, would we still see alpha or would average market returns rise overall?

“Isn’t it more about raising the overall standard of markets, which would be captured in the average market return? Wouldn’t investors, over the longer-term, be more concerned about how the benchmark developed and not how the deviation from that benchmark developed?”

Martin Skancke

Past performance doesn’t even guarantee past performance

Raghavendra Rau, who has studied the behavioural biases of investors and whether investors even understand what performance is, described an unusual pattern created by the US Security and Exchange Commission’s mandated holding periods for quoting returns: when a bad quarter no longer has to be included in the performance data, returns are boosted by the addition of a new, better-performing quarter, and although nothing has changed in the fund’s management or strategy, investor flows into the fund can be dramatic. Investments also flood in when funds simply rename themselves to reflect the current hot topic.

“This creates two big problems. One: if you call yourself a responsible investing fund, you have to be careful that people actually understand this. Two: be sure nobody else who’s not doing any kind of responsible investing calls himself a responsible investing fund and gets the benefit of the label.”

Raghavendra Rau

Rau noted that when returns are poor, funds don’t tend to quote numbers in their advertising literature, but when a bad return falls away, that’s when advertisements often appear saying “these are actual returns”. He said retail investors are unlikely to assess the underlying data, while even institutional investors struggle to justify not investing in stocks showing what he calls a “mechanical” rather than a real return.

“Any investment advert says past performance is no guarantee of future performance, but my research actually shows that past performance is no guarantee of past performance either!”

Raghavendra Rau

Maybe looking and hoping affects reality

Jean-Pascal Gond said that systematic analysis of previous studies has found a small positive relationship between corporate social responsibility and financial performance, but queried why, if we have the answer already, are we bothering to research it any further?

Surprisingly, the more academics research this topic, the more they tend to show a positive relationship; usually, the mean correlation between two constructs drops the more that academics study it. So Gond suggested making this research bias the object of inquiry, to explore how this bias happens and how practitioners and academics may be fuelling it.

“We’re all looking for a relationship and hoping that it’s there and maybe that affects reality. It reminds me of the Heisenberg uncertainty principle from physics, that you will change something just by observing it.”

Martin Skancke

Is long-term risk the narrative?

Skancke asked whether the responsible community’s quest for more and more financial data is actually a response to the internal structures within organisations, to try and convince CIOs and CEOs that responsible investment enhances financial returns, and if it is time to propose a different narrative about responsible investing?

Viehs said focus should be centred more on risk management than on adding alpha.

“Maybe we’re not making some extra money every month in excess returns, but maybe it gives us a better and richer understanding of some of the long-term risks that we’re facing. Maybe that in itself is the narrative?”

Michael Viehs

Next steps

In closing, Martin Skancke identified three key issues these findings present to the PRI: the agency problem between owners and managers of capital, the case for improving corporate performance through active ownership and the problem of freeriding because the returns on the efforts of active owners are shared among all investors.

“The challenge for the PRI is to be even more effective and efficient through our engagement platform, in bringing down the cost of engagement and making that a cheaper, more accessible option for investors.”

Martin Skancke

He also suggested that, historically, proponents of responsible investing may have focused too much on excess returns and might need to focus on aligning its activities with broader societal objectives, the values of beneficiaries, and risk.

Skancke left the audience with a final idea for future research: a sociological study on the relationship between responsible investing professionals and CIOs, because a lot of the fixation on alpha seems to be driven by responsible investing professionals’ need to justify their own ESG activities within larger organisations that do not yet have ESG embedded in their culture.