Forward View: The Challenges of ESG Investing

Forward View

The Challenges of ESG Investing

August 12, 2023

Investing is a balancing act… how do you get the best returns for the least risk?

Over the past few decades, a new generation of investors have tried to balance investment profitability with doing good. While there are a few variations of this (including faith-based investing), the most common framework is ESG (environmental, social, and governance).

It’s somewhat controversial and very subjective. How do you define a socially responsible investment? Is it avoiding businesses in certain industries? Is it finding the best-managed companies? Is it staying away from controversy? Or is it about finding companies that are good at solving everyday problems?

Everyone’s scorecard is going to look a little different. Everyone isn’t going to be happy with the same investments. Part of my job is building portfolios that match client preferences.

Just for fun, I ran through some screens on our growth stock portfolios. By normal ESG standards, we managed to have low risk exposure to carbon-based industries, animal testing, and stem cell research.

But we’ve also had greater than average exposure to military and defense stocks, particularly after the invasion of Ukraine.

For our dividend portfolios, we have a lot of companies in petroleum, manufacturing, and big pharma. Getting high dividend yields while doing ESG is tricky!

Investing in tech companies like Google, Facebook, and Apple can get controversial, too. While they are known to treat their employees well, there are some issues regarding anti-competitive practices, data privacy, “fake news”, and treatment of overseas contractors.

There is some research that suggests that ESG companies can outperform their non-ESG counterparts. A meta-analysis by Friede, Bush, and Bassen (2015) reviewed over 2,000 studies and found a positive correlation between ESG factors and corporate financial performance.

How about investor returns? Do ESG screens make a difference? Let’s make a quick comparison between the world’s largest S&P 500 Index ETF (SPY) and its socially responsible counterpart, the MSCI KLD 400 Social ETF (DSI). The KLD 400 is virtually identical to the S&P 500… without 100 of the “worst-offenders” from an ESG perspective.

Counterintuitively, the ESG index has slightly higher risk… note the larger upside/downside capture ratios relative to the benchmark. This is interesting simply because you’d expect the companies in this index to have fewer bad headlines, PR meltdowns, and social media disasters.

The socially responsible index compares well based on historical returns (even with a higher expense ratio). Net of costs, there was an added return benefit of 0.25% year. It’s incremental, but real.

Since last January, the performance gap has been much higher... over 1.4%.

Where do these excess returns come from? Is it strictly by “doing good”, or by doing something else?

One way to get insights on manager performance is by doing an attribution analysis. The first step is to look at sector exposure... you'll see that the ESG fund has more technology and less energy.

Morningstar also looks at other factors that can explain outperformance, including style (growth vs. value), yield (dividends), price momentum, quality (profitability), volatility (size of daily price swings), liquidity (overall trading activity), and size (large or small company).

Over the past five years, the ESG screens used in the MSCI KLD 400 Social ETF appear to have a bias towards technology companies and growth. This may have had the net effect of adding 0.25% to annual returns. It also explains the slightly higher risk.

As a professional futurist and investment manager, I enjoy looking at the intersection between finance and social trends. We live in a controversial world, and few things are more controversial in finance now than ESG. I’d like to think that we are investing in companies that are future focused. This means building long-term solutions for people, while still making sense from an investment perspective.

Jim Lee, CFA, CMT, CFP

Founder, StratFI

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Disclosure: Information contained herein is for educational purposes only and is not to be considered a recommendation to buy or sell any security or investment advice. Securities listed herein are for illustrative purposes only and are not to be considered a recommendation. The author and StratFI clients may hold positions in securities mentioned.