For quantitative analysts, investors and companies alike, environmental, social and governance (ESG) data has become a pillar of performance. We analyze some of the published findings about the correlation between ESG data and financial performance, and other use cases of the data.
- There is proven potential for excess returns at companies with high ESG scores. This has made ESG research a crucial part of the research process conducted by quants and investors.
- ESG issues will be a dominant investor theme of the 21st century.
- ESG investing can reduce portfolio risk and generate competitive returns.
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Sustainable investment has moved up the agenda of quants, investors and companies over recent years. It is now in the spotlight as millennials lead a drive to invest in ESG-focused companies, while companies seek to improve their ESG scores to meet investor demand for commitment to issues such as climate change, human rights, and diversity and inclusion.
This growing appetite for global change is fed by ESG data, an increasingly important element in the research process undertaken by quants and investors. Companies, too, are embracing ESG concepts as a means of attracting investment, raising financial returns and, as a side issue, avoiding investor activism.
It should be emphasized that the generation of outsized returns is not the only reason investors may want to allocate capital to securities with sustainable credentials.
Many would legitimately argue that needing to demonstrate alpha misses the point of sustainable investing, where the aim is to ensure that returns are not being made at the expense of the prosperity of future generations.
It is also reasonable to suggest that key risk mitigation factors associated with sustainable investing are unlikely to demonstrate results when looking at historical data.
The risk they are mitigating has not occurred yet, namely the mass transition to a low-carbon economy and/or the most severe effects of unmitigated climate change. Backtesting your portfolio on historical data will not tell you whether you are mitigating these future events well.
Nevertheless, some elements of ESG data do seem to correlate to performance.
The desire to recognize these correlations, and ideally to identify where there are causal relationships at play, is only likely to increase.
We have attempted to look at what our data and analysis can reveal about this, including reviewing how third parties — our clients and academics — have used data to demonstrate these emerging relationships between ESG data integration and financial performance.
ESG data and financial performance correlation
A Bank of America Merrill Lynch article in ESG Matters — Global argues that ESG considerations are no longer optional for investors, and provides quantitative evidence that incorporating ESG into an investment approach can enhance returns and reduce risk.
It states: “In [the] U.S., ESG has been a particularly effective signal of alpha (excess returns) over the past five years, potentially driven by the explosive asset growth and inflows into ESG-type strategies. Companies with high (top quintile) ESG ranks have outperformed their counterparts with lower (bottom quintile) ESG ranks by at least 3ppt during the time period.”
Looking at European markets, ESG Matters — Global notes that companies with higher overall ESG scores outperformed those with lower ESG scores during a backtesting period from December 2007 to August 2019.
Looking at the relationship between the number of ESG disclosures a company makes and investment metrics such as alpha or return on assets, the project team used Eikon Screener to retrieve a list of companies headquartered in the U.S., falling into the industrials economic sector, and with a market cap of over $10 billion.
These are early days in proving a correlation between companies’ ESG data and their financial performance, and there is no guarantee of a positive correlation. However, there are professional opinions that point to the potential of excess returns at companies with high ESG scores.
The article identified the top 20 percent of companies based on their number of disclosures on performance and policy metrics. Comparing these companies with the universe of large cap U.S. industrials used in the project, the research concluded that companies with the highest number of ESG disclosures significantly outperformed peers on profitability measures, such as return on equity and return on assets.
Using ESG data in the search for alpha
Another use case of ESG data by Refinitiv’s developer community is published in How to integrate ESG data into investment decisions, which focuses on using ESG data to seek alpha in equity markets.
The premise was to observe if a subset of companies with high ESG scores would perform better than the index they are part of. The S&P 500 index was used for the test, and the outcome showed companies with high ESG scores significantly outperforming the index.
Refinitiv ESG scores data was used in a recent research study by Probability and Partners, ESG Versus Financial Performance: The case of EU, U.S., Australia and South-East Asia.
The paper found that companies in the STOXX 600 and Australia ASX 300 with high ESG scores do not experience reduced returns. Meanwhile, companies with high ESG scores in the S&P 500, Japan Nikkei, China A-share, and South Korea KOR 200 tend to have lower volatility.
The impact of COVID-19
While the full effect of the COVID-19 pandemic on financial markets has yet to be assessed, a Refinitiv Lipper Alpha Insight published in April 2020, Monday Morning Memo: Are ESG Funds Outperformers During the Corona Crisis?, took a data-driven approach to evaluate whether funds that integrate ESG criteria in their portfolio management process showed outperformance compared with market benchmarks and conventional peers.
The analysis compared the performance of the 34,340 equity funds in the Lipper database and their Lipper-assigned technical indicator, essentially standard market benchmarks, over a period from January 31 2020 to March 31 2020.
Overall, 44.6 percent of the funds outperformed their technical indicators, while 55.4 percent showed underperformance. Comparing conventional funds with funds that integrate ESG criteria into portfolio management showed a similar split with the most conventional firms underperforming indicators and the majority of ESG funds outperforming.
The company and the investor
Recognizing growing demand for sustainable investment, many companies are reviewing their outlook on ESG disclosure. An article by Williams Market Analytics, These Companies Will Boost Your Portfolio Performance… And Your Morale, uses Refinitiv data to analyse the potential gains companies can achieve by focusing on ESG issues.
The article says: “Global companies’ performance on ESG issues is rapidly becoming more critical to their competitiveness, profitability and share price.”
It further explains that companies focused on ESG can both minimize risk to their business and operate more efficiently, and suggests ESG-focused firms tend to display lower earnings risk.
On the investor front, Williams Market Analytics says ESG will become “a dominant investor theme of the 21st century”, and encourages the integration of ESG into investing to reduce portfolio risk, generate competitive investment returns, and help investors feel good about the stocks they own.
Refinitiv Perspectives LIVE — ESG Investment, a cure all for Asset Management?
Environmental issues are often key company and investor ESG interests. A Refinitiv Perspectives article questions whether S&P 500 companies are prioritizing environmental sustainability.
In partnership with Quartz Creative, Refinitiv used its ESG data to develop data visualization that reveals companies in the S&P 500 that are prioritizing environmental sustainability, and those that are not.
Watch — The CO2 bubble: Visualizing carbon emissions and climate activism of every S&P 500 corporation
Of all the S&P 500 companies, 18 account for half of all CO2 generated. Some 354 of the companies have emission policies and, of those, 245 have specific reduction targets.
The good news is that 44 S&P companies tracking the EU Paris Agreement on emissions reduction account for 28 percent of S&P’s carbon emissions, which should have a considerable impact on total emissions. Also, more S&P companies are adopting emission targets driven by regulation, performance and stockholder pressure.
A case in point on emissions is Qantas, Australia’s leading airline. Having announced in late 2019 that it intended to reduce CO2 emissions to zero by 2050 and invest in sustainable fuel sources over the next decade, the company’s share price shot up.
A research note by MST Marquee said: “The market response to the Qantas announcement highlights the increasing influence of ESG funds.”
Diversity and inclusion
A Refinitiv article in American Banker, Diversity & Inclusion Yields Better Financial Performance, discusses the correlation between strong diversity and inclusion practices and economic returns.
Using Refinitiv’s Diversity & Inclusion (D&I) Index, Credit Suisse researched more than 3,000 companies in 56 countries. Results showed that for firms where more than 20 percent of the top managers are women, share prices rose more over the past decade than the shares of other companies.
Research by Morgan Stanley in 2016 showed similar results with the firm’s quant team looking at companies based on their metrics of gender diversity. The top third experienced an average of 2 percent higher returns than their peers.
This type of research is driving not only companies to increase commitment to D&I, but also investment managers to buy into these companies.
Wealth manager The Matterhorn Group found that companies with more women on their boards outperformed others with fewer female board members. As a result, the group launched a gender parity investment strategy, based on the Refinitiv D&I Index, and only considering a firm as an investment if it has a minimum of three women on its board or three women who are key executives.
Last, but not least, we review analysis from consultancy Alvarez & Marsal (A&M) published in Hedgeweek, Poor ESG performance increases likelihood of activist investor attention.
The analysis describes the use of Refinitiv ESG data to demonstrate that companies ranked in the bottom 50 percent of ESG performance are significantly more likely to attract activists’ attention.
Using Refinitiv ESG data covering about 1,300 European companies, A&M created a ranking of four quartiles based on ESG performance. Analysis of how many companies in each quartile had been the subject of activist campaigns since 2017 showed that poor ESG scores can be an early warning sign of activist pressure.
While these are early days in proving a definitive correlation between companies’ ESG data and their financial performance, the findings published in this blog point to increasing evidence of such a relationship.
Driven by investors’ interests in ESG issues and companies’ responses to both investors and regulators, it is likely to be only a matter of time until a clear correlation is widely acknowledged.