New evidence of the financial impact of ESG factors

August 20, 2014 Categories: Investment Strategy

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One of the items on my ‘To do’ list has been to write a blog about my colleagues’ recent ESG* (Environmental, Social and Governance) research work.

So imagine my surprise (secret delight…) when I finally managed to make some free time, sat down to write it and my US colleague, Bob Collie’s ‘New evidence of the financial impact of ESG factors’ blog appeared in my inbox. Now that is what they call great timing!

Here it is for you to enjoy:

Factor exposures (a.k.a smart beta) have become a big deal in investment. It’s no longer just about large vs. small or value vs. growth. There are potentially hundreds of exposures that investment managers can now track, analyse and manage.

New research by Leola Ross, Peiyuan Song and Will Pearce applies the factor analysis approach to the question of environmental, social and governance (ESG) factors. Specifically, they have found that institutional active managers tend to have a systematic tilt toward certain ESG factors. They argue that this could point to “an implicit endorsement of the consistency between ESG factors and value creation.”

This finding is significant because it is not based on the subset of managers with an explicit ESG agenda, but on the broad universe of active managers, a group whose only concern is to create the best possible performance record. In other words, this finding came from looking at ESG not through the lens of the investor’s values, but purely as an active management factor (“value” rather than “values”, if you like.)

The size of the systematic tilt varies across different markets, as does its focus: for example, U.S. managers seem to pay the most attention to questions of governance; in Japan environmental factors are most prominent. In all markets, there is a correlation between ESG factors and capitalisation.

Establishing the existence of these tilts raises several other questions. For example, many of the components of the ESG factors are risk issues more than return issues, so it would be fair to wonder whether the tilts are driven by return considerations or by risk considerations. Likewise, just because the tilts exist does not mean that they necessarily add value or reduce risk; the existence of the factors in itself does not tell us that their effect is necessarily a positive one. Like any factor, ESG factors can presumably become overvalued or undervalued at points in time.

The significance of the factors is not simple—just as the significance of other factors such as value, volatility and momentum is not simple—but it’s real.

So there are many unanswered questions that arise from this work. But we do now have hard evidence that ESG factors matter outside the context of traditional ESG mandates, and that is a notable finding.

*ESG stands for Environmental, Social and Governance. There is growing evidence that suggests that ESG factors, when integrated into investment analysis and decision making, may offer investors potential long-term performance advantages. ESG has become shorthand for investment methodologies that embrace ESG or sustainability factors as a means of helping to identify companies with superior business models. (http://www.esgmanagers.com/)

Mike Clark – Director, Responsible Investment

Russell Investments Wire - Mike Clark

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