Adopting ESG factors to improve returns, reduce risk

How traditional investment managers are looking at environmental, social and governance practices to identify top-performing companies

By Emily Bannister and John LaPann

Sep 24, 2013 @ 12:01 am (Updated 10:52 am) EST

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Over the last twenty years, the social investing industry has grown and changed. It has moved from “negative screening,” such as divesting from South Africa or excluding “sin stocks” from the portfolio, to a more positive approach that favors good companies and can even improve companies through shareholder advocacy and lobbying.

Socially responsible investing (SRI) has also attracted more investors. According to US SIF (The Forum for Sustainable and Responsible Investment), SRI assets under management are up 22% from 2010 through 2012, to $3.74 trillion. Since 1995, SRI assets have grown faster than professionally managed assets as a whole .

Whenever an area gains popularity so quickly, there is always the chance that money managers will offer products just to profit from the trend, not out of a genuine belief in the approach. Unfortunately, we find that there are strategies out there today that are “greenwashing” – marketing themselves as environmentally friendly when in fact their ESG criteria are not very strict. We also see a number of products being launched that may have good intentions, but may not have a good, disciplined investment process.

At Federal Street, we help clients navigate this landscape, finding managers with strong financial and social research capabilities. In the process, we've noticed that many of the evaluation factors that SRI managers use also provide valuable insight into the overall financial health and performance of companies.

The broader investment industry is coming around to the same opinion. Without identifying themselves as “social investors,” many forward-thinking investment professionals have begun looking at environmental, social, and governance practices as important factors when evaluating investments.

For example, they may notice that resource scarcity can create growth opportunities for companies with solutions to improve efficiency or replace fossil fuels. They may consider whether a company's poor record on labor practices could result in costly disruptions from a strike or regulatory action, or a consumer boycott. They may question whether a board's structure allows it to make the best decisions for all of the company's stakeholders.

From academics to investment managers to watchdogs, people in all corners of the investment industry have begun including ESG as a genuine consideration. The change has been less visible than the explosive growth in the SRI industry, but has a larger and more fundamental impact on capital markets.

ESG factors are being used as part of competitive analysis and fundamental analysis.

One indication that ESG factors are being adopted by the broader investment community is that Michael Porter, creator of the influential “Porter's Five Forces” framework used by many traditional stock analysts, recommends incorporating these factors when assessing the competitive position of a company. When Porter highlighted the need for corporate social responsibility to be considered in the analysis of competitive advantage, it legitimized ESG analysis for many mainstream investment professionals. In a 2011 article, Porter says, “The opportunity to create economic value through creating societal value will be one of the most powerful forces driving growth in the global economy.”

In turn, money managers are including these factors as data points that can help decide whether or not they buy the stock of a particular company. Looking at ESG trends can help investors find areas of growth, identify companies that are cutting costs by being more efficient, and avoid reputational and economic risks.

Investors have begun to formally incorporate ESG factors in their research process.

There are increasingly high-profile examples of the shift to include ESG factors as a way to boost returns. Wellington Management, an investment firm headquartered in Boston, MA that manages more than $750 billion in client assets, recently acknowledged that ESG factors are increasingly important to consider when managing portfolios and risk. Wellington is a large, traditional investment firm that has developed tools to analyze ESG information because it believes it can improve the investment process. To Wellington, “The motivation for ESG integration is simple: to increase financial returns while upholding the fiduciary duty to incorporate any known risks into the investment process.”

Other large, well-known asset managers have made similar moves, also for economically-driven reasons. Vanguard and BlackRock have both discussed plans to engage with hundreds of companies on governance issues. Pensions & Investments, a leading industry journal, profiled this effort, interviewing BlackRock's global head of corporate governance and responsible investment. According to the article, “'BlackRock's global corporate governance team is part of the company's investment function as opposed to the compliance or legal department,' Ms. Edkins noted. 'We think good governance adds value long-term,' she added.”

What gets measured gets done.

Many companies now provide an annual Corporate Sustainability Report as part of their regular reporting package to investors and stakeholders. To cater to this new demand, accounting firms such as Ernst & Young and PricewaterhouseCoopers offer services to verify sustainability reporting. A major data provider to the investment industry, Bloomberg, now tracks and reports ESG data points for all companies. Similarly, index provider MSCI, Inc. now offers ESG research and ratings on companies.

Now that the watchdogs have started to focus on these metrics, investors are more easily able to measure and compare companies on issues that were previously considered “soft.” As more investors track these ESG factors and make decisions based on them, they become more material to stock prices.

Strong performance and sustainability often go hand in hand.

At Federal Street Advisors, we have seen for years that investors who incorporate sustainability into their portfolios have been able to generate strong performance. Some of this performance is due to the skill of the ESG-focused managers that we work with, but some is also due to the objective value and advantage that including this broader set of tools can add. To help illustrate this “ESG advantage,” a team of professors at Harvard studied 180 companies from the early 1990s through 2010, splitting the group based on whether companies voluntarily adopted environmental and social policies, and found that, “In the 18-year period we studied, the High Sustainability firms dramatically outperformed the Low Sustainability ones in terms of both stock market and accounting measures.”

In a world where outperforming the benchmarks is a difficult feat, and active stock-pickers are always searching for an edge, the strong performance delivered by companies with good environmental, social, and governance practices is reason enough for the lines between “social investing” and “investing” to blur.

As the investment industry begins to embrace this reality, we keep looking ahead to find forward-thinking money managers and perspectives to help our clients achieve their goals. We believe that the investment opportunities of tomorrow will continue to be found in companies that are addressing the opportunities and challenges of the future. Looking at this future through an ESG lens can increase the probability of success.

Emily Bannister is the director of research and John LaPann is the founder and chairman of Federal Street Advisors.