Does ESG lead to outperformance?

Sustainable investing

Looking ahead, we believe it's more likely for outperformance coming from activism and engagement to drive an increase in quality in a company along the lines of ESG factors.


By Stephen Metcalf, head of Sustainable Investing – British Isles and Asia

It’s no longer a nice to have but a must have – ESG investments have increasingly become a popular point of discussion in the wealth and investment world. Mainly fuelled by an appetite to do more for global issues.

“Our clients are demanding more than just an ESG-branded fund. They want to know the true impact of their investments in addressing global issues like climate change and social inequality.’ Explains Samantha Brown, director, client relationship manager at RBC Wealth Management in London.

But, also by the opportunity for enhanced returns. However, the question of outperformance is still on the mind of many.

Investment professionals have been grappling with this question in recent years, driven by the continued proliferation of ESG-focused strategies, and particularly after the COVID-19-induced market pullback in March 2020.

Research conducted by Morningstar in the months following the drawdown concluded that there didn’t appear to be a performance trade-off associated with sustainable funds, and a majority of these funds actually outperformed their traditional peers over multiple time horizons, including holding up better during the sell-off.

Many reasons for this empirical relationship have been suggested, ranging from better downside risk protection to more long-term thematic arguments. Research conducted by MSCI, using its proprietary ESG ratings, suggests there are three major channels from ESG to financial value:

  1. Higher profitability (cash flow channel)
  2. Lower tail risk (idiosyncratic risk channel)
  3. Lower systematic risk (valuation channel)

Despite this research, however, voices from the other side of the debate continue to be heard, especially in 2021, which has seen ESG underperform in periods. Where the market narrative was dominated by the so-called “re-opening trade,” in which more cyclical and defensive names outperformed, ESG funds have lagged. While this has been sporadic, it’s led some to question the outperformance of ESG over a full market cycle, and whether it can keep pace going forward.

There may be some validity to this argument. While the first iteration of ESG strategies – the funds that have been around the longest – outperformed the broader market, this may be because they typically tilted toward higher quality, growth companies as a result of their ESG scoring. The argument says the performance could largely be replicated via a quality, growth strategy without ESG. Additionally, as ESG factors continue to be integrated into portfolios, any market inefficiency surrounding them will erode – and the first-mover advantage of some of these funds may be eroded.

Looking ahead, we believe it’s more likely for outperformance coming from activism and engagement to drive an increase in quality in a company along the lines of ESG factors. Being able to find the companies that are not considered “ESG” today, but will be tomorrow, will be a key source of outperformance in the space going forward.

Our approach to tackling climate change through portfolios

At RBC, one of our key areas of focus when looking at investment risk is climate change. We know the effects of climate change will not only impact how we live but have reaching effects on whole economies. Our approach is one of measure, manage and mitigate. To begin with we measure the environmental footprint of our portfolios. Then, manage the exposures within our existing investment process while looking to capture the numerous investment opportunities that exist in addition to mitigating the risk to the greatest degree possible. Given clients have different preferences in this space, and the multi-dimensional nature of the problem – we utilize a wide range of investment solutions.

Read more about sustainability pressures and investing in ideas of the future.

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