What is ESG and why does it matter?
Updated: Apr 26, 2022
ESG stands for Environment, Social, and Governance.
E is for Environment looks at the impact on our planet.
S is for Social tracks the impact on stakeholders like employees, customers, suppliers, the community, and our society.
G is for Governance of a business, and this focuses on the board of directors, business oversight, management attitude towards stakeholders, and good relationship with regulators.
Figure 1. Highlights of ESG Issues (Source: CFA Institute of Research Foundation 2020)
ESG is often used to evaluate what a company is doing to fulfill a broad range of socially desirable goals. But in addition to measuring the social impact of investments,, did you know that ESG factors can also be used to optimize the financial performance of your portfolio?
The Benefits of ESG Investing
ESG factors can be used in an investment strategy with financials to optimize returns and minimize volatility. Researchers at Harvard Business School found that stocks of companies that successfully manage important ESG issues outperform those that do not by an annualized alpha of 6%.
The Center for Research in Security Prices, LLC (CRSP) similarly found that incorporating material ESG data changes the resulting portfolio’s risk-return profile. In its backtested simulation, CRSP found that stocks of the “Best-in-Class” ESG companies outperformed the other companies by more than 50% between December 2014 - June 2021.*
Figure 2. Cumulative Return of $1
This data and information are based on data from the Center for Research in Security Prices, LLC (CRSP), ©2021.
The reason that ESG factors become drivers for better financial performance is through better risk management, higher operational efficiency, and more innovation.
ESG factors can also help your portfolio remain stable. A study in the Journal for Sustainable Investment and Finance found that ESG companies had lower stock price volatility than their industry peers - with 28% less movement on average, ranging from 6% (food and beverages industry) to 50% for the (energy industry) depending on the sector!
Figure 3. Annualized Volatility Comparison Between ESG and Reference
ESG Investing Best Practices
The key to ESG investing is to put ESG factors on par with a stock’s fundamentals, which is a best practice recommendation from the CFA Institute. Industry leaders can be identified based on a company’s financials, business model, management team, and operational efficiency. Next, look to a business’s ESG performance data to zoom in on those that are well-positioned to capitalize on opportunities in the transformation towards sustainable development.
To ensure that a business isn’t engaged only in “greenwashing,” make sure to look at quantitative data on the environmental and social impact of sustainable initiatives. The fact that a company is monitoring the impact of corporate initiatives can be a signal that the company is committed to managing its impact. Even if measuring its impact is not directly correlated with managing its impact, it is nevertheless a useful data point. This is also the reason we at Owl Investor insist on unlocking access to quantitative impact data and letting the data speak for itself.
Another thing to keep in mind is to look at updated ESG performance data. Today most companies update their self-reported ESG data annually. If real-time updates are not considered in the investment process, this can lead to missed opportunities. That’s why we at Owl Investor are making sure relevant updates are captured by our proprietary technology.
And since mutual funds and ETFs are indexes comprised of different individual stocks or other investments, this methodology can also be used on mutual funds and ETFs. We would evaluate individual components of a fund and tally up the total to get the aggregated performance of a mutual fund or ETF.
Potential Risks of ESG Investing
1. No Universal ESG Standards
Today we do not have a consistent set of standards to evaluate the ESG performance of companies. As a result, different rating agencies can assign a different rating to the same company depending on the evaluative criteria and the rigor of the assessment process. This presents challenges for evaluating a company’s ESG performance.
In an attempt to increase standardization, Owl Investor will take into account a company’s ESG rating and the quantitative impact data. Even though subjectivity can never be eliminated from self-reported data and impact estimates, as regulators solidify their requirements for company impact reporting, any subjectivity that remains will likely be similar in degree to the subjectivity that is present in a company’s financial reporting.
2. Lack of long-term data on ESG performance
The Harvard Business School research mentioned earlier in this post looked at data on more than 2,000 firms over 21 years and found that those that managed material ESG risks in their business well outperformed those that did not by an annualized alpha of 6%. From the perspective of ESG integration, material ESG information/considerations are considered because it is an important component of a complete and thorough financial analysis for any investment portfolio. Just as one would consider a stock’s fundamental financial information as part of the investment process, material ESG factors should be similarly included. Always remember, past performance is no guarantee of future results.
3. Companies may stop reporting ESG data
The possibility that companies will stop reporting ESG data exists, although the risk of its occurrence is not considered significant in light of recent reporting trends and regulatory actions.
Recent trends point to increased ESG reporting by public companies. In 2020, 95% of S&P 500 companies reported ESG data, as compared to 20% of companies that reported in 2011. This was an almost five-fold increase and is likely to continue.
Regulators in the U.S and across the globe are starting to pay attention to the need for standardized corporate sustainability reporting. For instance, Nasdaq’s Board Diversity Rule, which was approved by the SEC on August 6, 2021, is a disclosure standard designed to encourage a minimum board diversity objective for companies and provide stakeholders with consistent, comparable disclosures concerning a company’s current board composition. On April 21, 2021, the European Commission adopted a proposal for a Corporate Sustainability Reporting Directive (CSRD), to require large companies to publish regular reports on the social and environmental impacts of their activities.
Put it together, these data would suggest more companies will be reporting ESG data given regulatory expectations and corporate reporting trends.
As discussed above, the lack of a consistent ESG framework has created inconsistencies that present challenges to ESG evaluation. One would hope an increase in regulatory focus on this subject will make standardized impact data available to allow for an apples-to-apples comparison.