Ethics and alpha

Ethics and Alpha

Can investing responsibly enhance returns? We take an in-depth look at the relationship between responsible investing and performance.

Does investing responsibly mean sacrificing returns? Such a seemingly simple and innocuous question can cause all manner of confusion.

In search of clarity, we set out to provide a wayfinding tool for investors by trawling through the academic literature, interviewing the experts and contrasting the theory with reality. And while our focus is on equity markets, we also touch on some of the key factors to consider in fixed income and real assets.

Friedman’s objection

Nobel Prize-winning economist Milton Friedman said: “There is one, and only one, social responsibility of business: to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud.”1

Friedman, perhaps the 20th century’s most celebrated free-market economist, described the idea that businesses had a responsibility to wider society as a “fundamentally subversive doctrine”.

His seminal article for The New York Times Magazine, published in September 1970, sparked a furious debate as to whether firms can increase their value by incorporating environmental, social and governance (ESG) considerations into their business operations. While that argument continues to rage nearly half a century later, and has expanded out to include bonds and real assets, there is a growing body of evidence to suggest they can.

Bell Pottinger, KPMG and Miramax are recent examples of what can happen to established companies when they fail to heed ESG factors. And with governments and other agencies expected to continue tightening regulations in the coming years – whether by forcing companies to cut their carbon footprint, increase the diversity of their workforce, or improve their management structure – common sense suggests forward-looking firms that are quickest to react to the changing landscape will have a competitive advantage.

From an investor’s perspective, if firms can indeed increase their worth by being ‘responsible’, various questions follow: Is there money to be made by investing in funds that exclude companies if they fail to abide by certain ESG criteria? If not, does integrating ESG considerations into the investment process, to complement traditional valuation yardsticks, improve investment performance? Is it worth engaging with companies to improve their ESG credentials? And can investors do anything to combat market failures?

Common sense suggests forward-looking firms that are quickest to react to the changing landscape will have a competitive advantage

Empirical evidence

Following the publication of Friedman’s controversial article, initially the debate consisted largely of glib assertions that formed attempts to justify opposing philosophical standpoints. There was little effort to discover if firms which adopted sustainable business practices were rewarded by financial markets for doing so.

However, in recent years researchers from both academia and the asset management industry, drawing on an ever-expanding universe of data, have conducted numerous studies to establish whether such a relationship exists.

There is sufficient evidence to be confident firms that adopt sustainable business practices perform better over the long run, and this is in turn rewarded by financial markets.

According to researchers at the University of Hamburg and Deutsche Asset and Wealth Management, a positive relationship between ESG ratings and corporate performance was found in close to half of over 1,800 academic studies published since 1970, with a negative correlation being found just 10 per cent of the time.2 For instance, a July 2013 Harvard Business School study found that over an 18-year period, a sample of 90 ‘high-sustainability’ companies “dramatically outperformed” 90 low-sustainability firms in terms of both stock market and accounting measures.3

Similar findings have been found for other asset classes. For instance, a 2016 study by Barclays analysts found a “small but steady” performance advantage by imposing either a positive or negative tilt to different ESG factors on a portfolio of US investment grade corporate bonds.4

As for real estate, a 2008 report by The Swedish Foundation For Strategic Environmental Research found rising resource prices, tougher national and international regulations, shifting tenant demands, and the opportunities presented by new building materials and technologies are all increasing the financial materiality of ESG issues to the real estate investor.5

There are, however, problems with a number of these studies. For a start, as Halbritter and Dorfleitner point out, most are based on short time series as rating agencies tended not start their work before the start of the current millennium.6 More problematic still, it is difficult to measure ESG criteria in a consistent and purely objective fashion. Since there are several specialised agencies producing ESG ratings, with significant variations in their methodologies, it is important to allow for these differences.

Crucially, many studies fail to differentiate between correlation and causality. Often when a correlation is found, it is interpreted to mean high ESG scores lead to improved financial performance. But it could be that stronger financial performance is allowing companies to invest in steps likely to boost their ESG scores. With most studies failing to explain the mechanism that led to improved performance, Harvey et al (2016) warn that simply focusing upon historical data runs the risk of “correlation mining”.7

There is sufficient evidence firms that adopt sustainable business practices perform better over the long run

Logical explanations

Nevertheless, there are logical explanations as to why high, or improving, ESG ratings might boost investment returns. Firstly, assets underpinned by high ESG ratings are likely to be less risky. For instance, while in the short term firms may in some instances be able to get away with exploiting their customers or workforce, or degrading the environment, common sense suggests they will eventually be damaged by such behaviour. Indeed, according to a 2018 Bank of America Merrill Lynch report, an investor who only bought stocks with above-average Thomson Reuters’ environmental and social scores five years ahead of the event would have avoided 90 per cent of the S&P 500 companies that went bankrupt between 2005 and 2017.8

The analysts said ESG-based investing would have offered long-term equity investors substantial benefits in mitigating price risk, earnings risk and even existential risk for US stocks. They concluded ESG provided “the best signal for future investment risks”.

Secondly, there is plenty of evidence to suggest highly-rated firms have a lower cost of capital. A number of studies have found good environmental performance correlates with a lower cost of debt and stronger credit ratings (Graham and Maher;9 Bauer and Hann;10 and Schneider11), and one found the same for good employee relations (Bauer et al.12). As for firms’ cost of equity capital — the internal rate of return (or discount rate) the market applies to a firm’s future cash flows to determine its current market value — studies by Dhaliwal et al13 and El Ghoul et al14 are among those to have found that improved corporate social responsibility (CSR) can lower firms’ cost of equity capital, thereby enhancing their value.

While sceptics have suggested sustainability and the cost of capital were correlated simply because they were both affected by other variables, this latter study established a persistent link between ESG and the cost of equity capital even after accounting for many other variables, including industry, size, ‘beta’ and leverage.

The authors hypothesised that high-scoring CSR firms enjoy a lower cost of equity capital than low CSR firms due to the latter having a smaller investor base and higher perceived risks. They also concluded that managers of low-scoring CSR firms should consider increasing investments in CSR-related activities, “especially in the areas of employee relations, environmental policies and product strategies”.

However, even if there are strong grounds for believing there is a relationship between ESG rankings and corporate performance, it has not always been clear investors have been able to profit from it in their portfolios.

Studies have found that improved corporate social responsibility (CSR) can lower firms’ cost of equity capital

Negative screening: the jury’s still out

The ESG market segment has grown strongly in recent years. Socially responsible assets under management globally grew to US$23 trillion in 2017 — more than a quarter of the total, and up 27 per cent on 2014, according to the Global Sustainable Investment Alliance. However, many industry participants are yet to be convinced of the merits of sustainable investing. According to one recent survey of 500 pension funds, foundations, endowments and sovereign wealth funds, nearly half expressed concern it could hurt performance.15

Their caution is perhaps not so surprising when one considers that historically, ‘responsible’ investing consisted of mutual funds that avoided various companies – such as arms and tobacco manufacturers or fossil-fuel extractors – and which were designed to appeal to certain investors’ ethical views. More recently, some funds have adopted positive screening – only investing in highly-rated companies. The problem with either approach is that having fewer companies to choose from implies fewer profitable opportunities.

For instance, while the bulk of research may appear to show firms can enhance shareholder returns by improving their ESG rating, Fabozzi et al have found evidence that investments in alcohol, tobacco and arms manufacturers — so-called ‘sin stocks’ — can generate abnormal returns over lengthy periods.16 One explanation that has been put forward is that since so many investors shun them, these assets can often be underpriced. In the case of tobacco stocks, it could be the market tends to undervalue their defensive qualities and high dividend yields, choosing instead to focus on the companies’ limited growth prospects.

A multitude of studies have tried to establish the financial implications of investing in ethical mutual funds. While some pointed to significant underperformance compared with conventional equity mutual funds, and a few others documented the opposite, the majority appear to suggest the difference in average performance between the two is scarcely significant (see for example Statman;17 Bauer et al;18 Benson et al19).

Brière et al20 conclude that while on the one hand socially responsible screening plays a minor role in explaining the “performance evolution of many mutual funds”, this means ESG investors can achieve portfolio performance equivalent to that of conventional funds while also achieving their ethical objectives.

“This modest average contribution … may seem disappointing. But it also means… investors can do equally well or badly while doing good,” they argue.

ESG investors can achieve portfolio performance equivalent to that of conventional funds

ESG integration works

That the research does not find a compelling case for investing in ethical mutual funds should come as little surprise since these funds were never designed to outperform in the first place.

Yet even if one concludes there is little financial reward from investing in such funds, that does not necessarily imply there is no merit in applying ESG criteria in other ways. Although Halbritter and Dorfleitner are among those to argue it is difficult to detect a relationship between ESG ratings and corporate performance which is exploitable, plenty of other studies suggest the opposite.

“It stands to reason that, if one believes ESG factors can help drive asset price performance, there is a relationship to be exploited by investors,” according to Steve Waygood, chief responsible investment officer at Aviva Investors. In recent years investors have moved away from applying screens, of either the negative or positive variety, towards integrating ESG considerations into mainstream investment processes and areas such as impact investing.

Waygood says the rationale for doing so ultimately boils down to the extent to which you believe in the efficient market hypothesis – the idea asset prices fully reflect all available information and it is impossible to ‘beat the market’ consistently on a risk-adjusted basis.

Proponents of this theory would contend if a high ESG rating helps a company lower its cost of capital and signal it is a less risky investment, this should rapidly be reflected in the price of its assets. However, as Waygood explains, there is plenty of evidence to suggest markets are far from perfect. “Nowhere are their imperfections more glaring than when it comes to looking at ESG factors, which many investors simply pay lip service to,” he says.

According to Professor Gordon Clark of Oxford University’s School of Geography and the Environment, the picture is clouded partly because some studies look at a firm’s absolute ESG score and others a change in that score. It is important to distinguish between the two as it is the latter investors can primarily look to profit from.

“An increase in an ESG ranking will get shareholder attention and attract a premium. It might not last a long time but it certainly will attract a premium. Likewise, a decrease in an ESG score will attract a penalty,” argues Clark. Furthermore, he suggests the opportunity to add value is especially true of smaller companies where “considerable information asymmetries can persist”.

Clark adds although there is likely to be less money to be made by simply investing in companies which already boast high ESG scores, even here there is an opportunity to add value to the extent not all issues will be fully understood by markets and factored into share prices. For instance, a 2016 study by Shank and Shockey found an equally-weighted portfolio containing the shares of the firm ranked highest on corporate sustainability performance within 18 different industry sectors delivered 3.68 per cent a year between September 2002 and March 2013. That compared favourably with the average annual return of the S&P 500 of 2.11 per cent, with the difference adjudged statistically significant.21

The opportunity to add value is especially true of smaller companies

Short-termism and distorted incentives

Waygood says there are a number of reasons asset prices fail to accurately reflect ESG considerations. For a start, he believes since it is in the commercial interest of investment banks’ corporate broking arms to maintain strong relations with their clients, researchers often fail to account for ESG factors in their analysis.

“To disparage a client or potential client of the investment bank may not be beneficial for the bank or for the analyst’s career. This has consequences for the efficient functioning of markets,” he says.

A lack of complete and comparable ESG market data, institutional investors’ lack of expertise on ESG considerations, or the syllabus of the Chartered Financial Analyst qualification are other barriers to efficient markets. But perhaps the most important source of market inefficiency is the incentives within the system that lead to excessively short-term views prevailing.

Company boardrooms and most financial analysts are preoccupied with quarterly results, while fund managers are too often incentivised to invest in a way that is more akin to speculation than genuine ownership. As a result, more weight is attached to the short-term costs or benefits of an initiative than the long-term ones; whereas many ESG considerations are only likely to play out over the long term.

The other main reason ESG criteria are often not factored in is they are subjective and assessing the impact of failures is complicated. Take the issue of climate change. Scientific evidence overwhelmingly suggests man-made climate change is happening, and the need to cap temperature increases will have major implications for a wide range of industries. But it will take years for the full impact of climate change to be felt, and its consequences are hard to quantify.

Financial analysts often use a ‘discounted cash flow’ framework for valuing financial assets. For example, they may sum estimated cash flows for the next five years and then add on a ‘terminal value’ for the business as a means of valuing all the increasingly uncertain future cash flows beyond this point in time.

Unfortunately, this methodology is of little use when it comes to accurately pricing many financial assets. For instance, coal deposits owned by mining groups are widely assumed to have a decade or more of life left in them. And yet all the indications are that carbon emissions will be taxed increasingly heavily, potentially forcing companies to abandon deposits altogether. The same goes for the rest of the fossil fuel sector. Oil and gas explorers will simply not be able to extract all their reserves if the objective of the Paris Agreement – to cap a rise in world temperatures at two degrees centigrade – is to come even close to being met.

However, whereas a value can be attached to a drop in sales growth or an increase in a dividend payout, valuing this kind of risk to the quality of an oil explorer’s earnings is more subjective. Because the outcome is so uncertain, the market completely disregards the issue. In turn, that means there are inefficiencies to be exploited by investors prepared to analyse companies’ long-term prospects in sufficient detail.

Integration and the measurement problem

Unfortunately – and perhaps one of main reasons why people still question whether ESG can add value – it is difficult to accurately quantify the value of embedding ESG considerations into the investment process. Aviva Investors’ global head of governance, Mirza Baig, explains that since it is just one of multiple investment considerations, “disentangling its effect on fund performance from other factors is impossible to do in a purely objective way”.

Nonetheless, both he and Waygood insist there is overwhelming evidence ESG data can give investors valuable insight into how well a business is run, where its material risks lie and how sustainable its business model and practices really are. As a result, there is no logical reason why fund managers who have not already done so would not wish to broaden their investment process by integrating material non-financial data.

The collapse of Enron, and the Deepwater Horizon oil disaster and emissions-cheating scandal that wiped billions off the value of BP and Volkswagen respectively, are three of the more high-profile examples of hugely damaging ESG failures in recent memory.

While it may be impossible to spot all these failings in advance, Waygood believes investors can identify enough of them to justify integrating ESG considerations into their decision-making process. “Our active equity portfolios sold out of VW shares not long before the emissions scandal broke in September 2015 due to a suspicion the company’s governance wasn’t of a sufficiently high standard. We did not know an emissions scandal was about to happen but we no longer trusted the management team,” he says.

None of this implies integrating ESG considerations into the investment process in a thoughtless fashion is likely to add value. Since correlations are liable to change over time, and as correlation does not evidence causality in the first place, simply taking external data feeds, pumping information into a quantitative model, and expecting that to lead to outperformance is wishful thinking.

It is necessary to spend sufficient time analysing each individual company: the quality of its management and transparency of its reporting; how likely it is to be impacted by regulatory changes; the broader political and environmental risks; and assess how well placed is it to respond to these challenges relative to its competitors.

Baig sees ESG as a factor all fund managers should incorporate into their valuation and risk-management processes. Sometimes it can be a dominant one, other times less so. “It is not an ESG team’s role to tell fund managers not to invest in a particular sector. That decision is ultimately down to the client. Rather, its role is to help them understand the risks associated with individual companies, and as much as possible price the risks appropriately. If the client wants to be invested in say the mining or tobacco sector, it is important the fund manager invests in the right company,” he says.

There is a decision to be made in terms of how much time and money should sensibly be devoted to engaging with companies

Engage or divest?

Incorporating ESG criteria into the investment process can improve returns in other ways. Since the evidence suggests companies can create value by improving their ESG scores, it makes sense to engage with them to help improve their approach. For example, investors may wish to encourage an oil company to improve its safety record to lessen the danger of oil spillages, or to be more transparent in assessing the  risks it faces due to climate change. Such improvements are likely to be rewarded by the market, even if not immediately.

Having said that, there is a decision to be made in terms of how much time and money should sensibly be devoted to engaging with companies, not least because there is likely to be a ‘free-rider’ problem with other investors potentially benefitting from those efforts. Collaborating with other investors can often make sense.

Reforming markets

It is also important to recognise the limits to what engagement can achieve in the face of specific market failures; including the inability to correctly price the impact of climate change and the depletion of natural resources such as fish stocks and fresh water. While it is primarily the responsibility of governments to ensure the global economy operates in a sustainable fashion, here too the investment industry has a role to play by engaging with governments, regulators and supranational institutions to ensure markets work as efficiently as possible.

For example, the lack of comparable and consistent data on ESG considerations contained within companies’ stock exchange filings around the world is a major problem when it comes to making investment decisions. A United Nations’ initiative in 2008, which Aviva Investors led, aimed at getting all the world’s major stock exchanges to change their listing rules, should help to solve this. To date, more than 60 exchanges have signed up to the Sustainable Stock Exchanges initiative, the goal of which is to improve the extent to which companies disclose their compliance with different sustainability criteria.

More generally, by ensuring governments and regulators set the right standards, create fiscal measures such as carbon taxes, or set up market mechanisms such as carbon trading schemes, fund managers can help ensure externalities are correctly priced. Researchers at the University of Cambridge and Erasmus University in 2013 estimated methane emissions caused by shrinking sea ice from just one area of the Arctic could cost a staggering US$60 trillion, equivalent to the previous year’s global economic output.22

While the accuracy of the estimate is open to debate, there is little doubt huge market distortions will be created if governments fail to tackle this issue urgently. By encouraging them to do so, fund managers can create value for their clients by putting their capital to work in the right places.

The trend is clear

With evidence mounting that raising ESG standards leads to improved corporate performance, companies are now paying ever more attention to these considerations. This is being reinforced by the sheer weight of money flowing into responsible investments, which is forcing fund managers to take ESG criteria seriously too.

According to the Bank of America Merrill Lynch research note, a “wall of money” is poised to flow into ESG strategies. Potential inflows from ‘millennials’ alone could drive US$15-20 trillion into ESG-oriented strategies over the next two to three decades, which is roughly equivalent to the size of the S&P 500 index today. Such developments would push ESG considerations ever further into the mainstream.

That the debate sparked by Friedman continues to rage nearly 50 years later is partly because his comments have frequently been taken out of context. In a forgotten part of the oft-quoted article he also said the responsibility of a corporate executive is to “make as much money as possible while conforming to their basic rules of the society; both those embodied in law and those embodied in ethical custom”.

To the extent he meant it is not the purpose of a business to give money to philanthropic causes unless it is going to benefit it financially, for example by improving its image and the value of its brand, or as Friedman put it “the business of business is business”, Waygood agrees with him. Where he disagrees is with Friedman’s definition of what it means to be a socially-responsible company.

“He was wrong to define it as doing things other than the core business. Meeting basic rules of society: whether it is labour standards, environmental protection or good governance standards, are fundamentally important to all businesses,” Waygood says.

However you define it and subsequently measure its impact, it is becoming extremely difficult to argue against incorporating some level of ESG analysis into investment decisions. While investors need to be wary of overpaying for assets based on ESG criteria alone, there is every reason to believe investing responsibly, far from leading to returns being sacrificed, will pay off.

Definitions

Negative screening

Avoiding controversial stocks or sectors based on ethical concerns about their product or production process. This can originate for a number of areas, such as faith-based concerns, conflict with the mission of a charity or foundation, or personal values.

Positive screening

Steering investments toward companies providing solutions to social, ethical or environmental problems. Some forms represent a relatively mild tilt of a conventional portfolio, such as best of sector. Other forms can be much more exclusive, such as social enterprise impact investing or funds that invest exclusively in solutions to one theme such as climate change.

Engagement

Using the influence of ownership, particularly but not limited to, the rights associated with equity ownership. Also applies to other asset classes such as corporate debt, real estate, and infrastructure. Some investors are experimenting with government bond engagement.

Integration

The integration of material environmental, social and corporate governance issues into the asset management philosophy and process – ideally including security selection, portfolio construction and portfolio risk management. 

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Investment thinking from Aviva Investors
  1. The Social Responsibility of Business is to Increase Its Profits, The New York Times Magazine, September 13, 1970
  2. Friede G, Busch T & Bassen A (2015): ESG and financial performance: aggregated evidence from more than 2000 empirical studies, Journal of Sustainable Finance & Investment
  3. Eccles R, Ioannou I, & Serafeim G (2011): The Impact of Corporate Sustainability on Organizational Process and Performance, Working Paper Harvard Business School
  4. Sustainable investing and bond returns, Barclays research study into the impact of ESG on credit portfolio performance
  5. Hagart G & Knoepfel (2008): The value of environmental and social issues to real estate investors, The Swedish Foundation For Strategic Environmental Research
  6. Halbritter G and Dorfleitner G (2015). The wages of social responsibility — where are they? A critical review of ESG investing, Review of Financial Economics, vol. 26
  7. Harvey C, Liu Y & Zhu C (2016). “...and the Cross-Section of Expected Returns.” Review of Financial Studies, Vol. 29, No. 1, PP 5-68
  8. The ABCs of ESG, Bank of America Merrill Lynch research note published 10 September 2018
  9. Graham A & Maher J (2006). Environmental Liabilities, Bond Ratings and Bond Yields, in: Freedman, M., Jaggi, B. (eds.), Environmental Accounting: Commitment or Propaganda, Advances in Environmental Accounting & Management, Vol. 3, Elsevier Ltd. pp. 111-142.
  10. Bauer, R & Hann, D (2010). Corporate Environmental Management and Credit Risk, Maastricht University, European Centre for Corporate Engagement
  11. Schneider, T (2010). Is environmental performance a determinant of bond pricing? Evidence from the U.S. pulp and paper and chemical industries. Working Paper: University of Alberta.
  12. Bauer, R, Derwall, J & Hann, D (2010). Employee relations and Credit Risk. Working Paper Maastricht University and Tilburg University.
  13. Dhaliwal, D, Zhen Li, O, Tsang A & Yang Y, (2011). Voluntary Nonfinancial Disclosure and the Cost of Equity Capital: The Initiation of Corporate Social Responsibility Reporting. The Accounting Review, Vol 86 No 1, pp 59-100
  14. El Ghoul S, Guedhami O, Kwok C & Mishra D (2011). Does corporate social responsibility affect the cost of capital? Journal of Banking & Finance, Vol 35, Issue 9, pp 2388-2406
  15. Investors fear ESG investment will hurt returns, Financial Times October 11, 2017https://www.ft.com/content/112dd68a-ad01-11e7-beba-5521c713abf4
  16. Fabozzi F, Ma K & Oliphant B (2008) Sin Stock Returns. The Journal of Portfolio Management, 35(1)
  17. Statman M (2000) Socially responsible mutual funds. Financial Analysts Journal 60(4), pp 44-53
  18. Bauer R, Koediji K & Otten R (2005) International evidence on ethical mutual fund performance and investment style. Journal of Banking & Finance, 29(7) pp 1751-1767
  19. Benson K, Brailsford T & Humphrey J (2006) Do socially responsible fund managers really invest differently? Journal of Business Ethics, 65(4) pp 337-357
  20. Brière M, Peillex J & Ureche-Rangau L (2016) Do Social Responsibility Screens Matter When Assessing Mutual Fund Performance? Financial Analysts Journal 73(3)
  21. Shank T & Shockey B (2016) Investment Strategies when selecting sustainable firms, Financial Services Review, Vol 25, No. 2
  22. Cost of Arctic methane release could be ‘size of global economy’: Nature, July 2013could be ‘size of global economy’

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This document is for professional clients and advisers only. Not to be viewed by or used with retail clients.

Except where stated as otherwise, the source of all information is Aviva Investors Global Services Limited (AIGSL). As at 31 October 2018. Unless stated otherwise any views and opinions are those of Aviva Investors. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Information contained herein has been obtained from sources believed to be reliable, but has not been independently verified by Aviva Investors and is not guaranteed to be accurate. Past performance is not a guide to the future. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested. Nothing in this material, including any references to specific securities, assets classes and financial markets is intended to or should be construed as advice or recommendations of any nature. This material is not a recommendation to sell or purchase any investment.

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