What’s The Evidence Of Better Returns From Responsible Investment?

By Barry Coates, May 23, 2019

There has been a long-running debate in the investment world between those who invest solely on basis of financial criteria and those who look at non-financial factors such as social, environmental and governance (ESG) factors. This paper supports the overview on returns, and dives into the detail of the evidence. 

For many years, the dominant investment approach followed the economist Milton Friedman when he said that the business of business is business, and rejected the notion of social responsibility. However, the movement towards corporate social responsibility and triple bottom line reporting has grown over recent decades. The companies that have shown leadership on ESG issues have provided the data to compare their financial returns to the mainstream.

The balance of evidence has shifted in recent years. There is now growing evidence that returns from responsible investment are, on average, at least as high as from conventional investing, and probably higher.

The investment sector has started to wake up to this evidence. While they were reluctant to embrace the idea of ethics in the early days, but as soon as there was convincing evidence of higher returns (‘alpha’) and lower risk (‘beta’), ESG investing has become popular.

The United Nations-linked Principles for Responsible Investment (PRI) has seen its membership grow rapidly from start up in 2010 to the current level of around US$90 trillion of assets under management. It's members undertake to incorporate ESG issues into investment analysis and decision-making processes. Link: 

Myths take a while to disappear, and many investors are still under the impression that returns are lower from responsible investment. There is good news for all those investors. High ESG standards are associated with high returns and low risk, as well as a positive impact on the environment and people. The relevant question isn't why invest ethically - it's why not!

An overview of the evidence

• There are many reasons why companies that do good also do well financially.
• Overall, good portfolio investing means good financial returns.
• Long term studies show responsible investing earns as much or more than conventional investing.
• Higher returns are shown in some long-term comparative indexes.
• Higher returns are also shown for responsible investments in Australasia.
• Despite the above, there are no guarantees that any specific responsible investment fund will earn high returns. There are always risks with investments, and responsible investing is no exception.

The good news is that, as well as good financial returns, there are also other benefits from being responsible. You invest in ways that align with your values, you shift money away from companies that pollute the environment and exploit people, and you create societal benefits.

Read on if you want to see details of the evidence!

There are many reasons why companies that do good also do well financially

Companies that behave ethically avoid fines for environmental damage, have a better reputation (which is important for their brand value) and have loyal and productive employees.

There may be some short-term gains from behaving badly, but it makes sense that companies that behave more ethically will ultimately outperform their unethical competitors. For example:

• staff working on the products or services sold by an ethical company will be more motivated to join and work hard than the staff being treated poorly, and they will stay longer
• consumers will be more satisfied with products or services they are buying from a company with strong values
• companies with high standards will face less risk of fines, lawsuits or a loss of reputation because of low standards.

These benefits are especially important in an era when the value of intangible assets, including brand, reputation and goodwill, accounts for around three quarters of shareholder value for most companies.

Good portfolio investing means good financial returns

Because portfolios are collections of companies, high environment, social and governance (ESG) standards for individual companies result in high ESG scores and good financial returns for the overall portfolio.

There is increasing empirical evidence that investing in companies that have good performance on Environment, Social and Governance (ESG) factors results in higher financial returns and lower risk. Because investment portfolios are a selected group of companies, that is true for investment funds as well the individual companies. This is a reverse of the outdated arguments that responsible investing leads to lower returns.

Long term studies show responsible investing earns as much or more than conventional investing

There is growing evidence from credible research institutes, universities and companies showing that, on average, it pays to invest responsibly.

A time series of companies over 20 years, in a comprehensive analysis by Harvard Business School Associate Professor, George Sarafeim, shows the benefits of companies reducing their costs by cutting waste and pollution, and increasing their income through innovating around sustainability. Companies with good sustainability practices had average returns 4.8% per year higher than those with poor sustainability.

A major reason for the link between ethics and returns is that shareholder value is largely dependent on intangible assets, including the value of company reputation, brands and its ethical performance.

Analysis by Bank of America Merrill Lynch shows higher returns from responsible investment portfolios (those with high ESG ratings) and lower risk. The analysis created 4 categories for ESG scores and found significantly higher average returns for those investments in the top two quartiles. The impact on risk was even stronger, showing far lower downside risk and bankruptcies from companies rated highly for responsible management.

Reviews of research studies also show positive financial impacts from responsible investments. Deutsche Bank (2012) looked at more than 100 academic studies of sustainable investing around the world, 56 published research studies, 2 literature reviews and 4 meta-analyses, in what the authors claimed to be the most comprehensive review of the literature undertaken. The research found that responsible investment was shown to have a positive impact in 77% of studies, 22% showed no impact, while only 1% had a negative impact.

A meta-analysis of 200 studies published by the Smith School at Oxford University shows a large majority of companies with good sustainability practices had lower cost of capital, better operational performance and higher share price increases compared to the mainstream.

Morgan Stanley carried out an analysis of over 10,700 funds, using Morningstar data on exchange-traded and open-ended funds active in any given year from 2004-2018. The key findings, as referenced in this Morgan Stanley article, were:

• No financial trade-off in the returns of sustainable and traditional funds
• No statistically significant difference in total returns between ESG focused, traditional funds and ETFs
• Sustainable funds may offer lower market risk

The research also found that in periods of extreme market volatility, such as 2008, 2009, 2015 and 2018, sustainable funds downside deviation was notably smaller than traditional funds.

Higher returns are shown in some long-term comparative indexes

The high return from ESG portfolios is shown by the track records of stock market indexes made up of companies screened by environmental, social and governance (ESG) criteria. The longest-established index, the MSCI KLD 400 Social Index (previously known as the Domini 400 Social Index) saw an annualized rate of return of 7.64% over the last 10 years through May 2017, compared to 4.87% for the Standard & Poor’s 500 Index over the same period.

In 2015 Morgan Stanley research looked at the same MSCI KJD 400 index over a longer timeframe and showed that annual returns beat the S&P 500 by 45 basis points till 2014 since its inception in 1990. The latest data for the MSCI KLD 400 index is shown below.

Nordea Markets uses MSCI’s sustainability ratings of companies to analyse their financial performance. Their analysis shows the top ESG performers have had higher financial returns of 5% per annum on average since 2012, compared to the bottom ESG performers. High ESG standards are also associated with lower volatility and risk.

Higher returns are also shown for responsible investments in Australia and New Zealand

In Australia, RIAA research showed responsible investment out-performed the comparable returns for average mainstream funds year on year.

The New Zealand Super Fund uses a combination of negative screening and ESG analysis. They have undertaken a review of the research and concluded that companies that do well on ESG metrics, do well financially. They recognise that more than 80% of relevant studies show positive links between ESG ratings and measures such as lower cost of capital, higher profitability and higher share price.

Despite the above, there are no guarantees that any specific responsible investment fund will earn high returns

There are always risks with investments, and responsible investing is no exception.

The evidence of higher returns is mixed when negative screening is the main tool for investing responsibly. The NZ Super Fund review notes that the positive results from ESG investing are not reflected for negative screening. In particular, there can be lower benefits from diversification for portfolios that are screened to exclude a large number of economically significant sectors.

However, there is contrary evidence that negative screening can result in better returns in cases where systemic risk is being avoided. For example, the sharp decline in coal prices and bankruptcy of major coal producers in recent years has shown the financial benefits from divestment of coal. A broader analysis of fossil fuel divestment, undertaken by the academics from the University of Waterloo in Canada, looked at different scenarios of divestment from coal, oil and gas and utilities. They found positive returns from each variant of divestment in the 2011-15 timeframe.

There is little data available for the field of impact investment, where companies are aiming to provide positive social and environmental benefits. The expectation is that returns will be lower, and some funds are explicit about their trade-offs in accepting a lower rate of return in order to achieve high social benefits. However, an interesting study from Cambridge Associates shows comparable returns from the more mature impact investments. This suggests that the sacrifice of financial return for doing good may be less than expected.

There are still RI sceptics and some studies still suggest that returns from responsible investment are not higher than mainstream practice. However, the evidence is strong, and growing, in favour of the view that responsible management is good management, and over time, companies will earn higher returns with lower risk. However, the studies are measuring average returns across many different funds, and don not apply to all finds. Investors should be careful with their investment decisions, and as the disclaimer says, past returns are no guarantee of future performance.

Visit the Mindful Money website and find the fund that fits your values.

Barry Coates
Founder and CEO of Mindful Money

• MSCI KLD 400 Social Exchange Traded Fund (ETF)