ECG On ESG Performance

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Image by Luan Rezende from Pixabay

Following up on my blog last month on Sustainable Investing, I have monitored the health of ESG by performing an investment ECG. I replaced electrodes with data by monitoring the returns over the last five years for ESG and regular equity indices. A review of the performance graphs shows a clear pattern of ESG outperformance. But like most diagnoses, identifying the underlying causes is complex.

Setting Up The Test

While I didn’t need to connect a complicated mass of wires, getting the data together was almost as challenging. MSCI is the largest provider of ESG benchmark indices. The Choice ESG Screened Indices are the most rigorous ESG equity indices. They cover Canadian, U.S., and EAFE (Europe, Asia, Far East) equities. The companies in the Choice indices are selected from those in the regular MSCI indices in each geographic area. They must satisfy a minimum ESG score requirement and cannot be involved in any severe controversies. The companies also cannot be materially involved in the business activities listed in Table 1.

Table 1: Excluded Business Activities

I simulated the returns that may have been available to an investor in ETF’s that are indexed to these indices. I did this by deducting the management expense ratio (MER) of the relevant iShares ETF from each index as shown in Table 2. Then I compared the MER adjusted returns of the ESG indices to those of the regular ones over the last 5 years, by geography, to the end of 2020. I could not use the returns from the ETFs as they were only recently launched in April 2020.

Table 2: ESG and Regular iShare ETF MERs

Reading the Lines

Chart 1 below shows the results of the test. The red line is the pulse of the monthly MSCI Canada Choice ESG Screened Index returns divided by the monthly returns for the regular MSCI Canada Index. The Canadian ESG index has been very vigorous, outperforming the total return of the regular index by 22% over the last 5 years. The blue line shows that the U.S. ESG index has also been hale, outperforming the regular index by 20%. The orange line shows that the EAFE ESG index has not been as robust as the others. But the EAFE ESG still had a good rhythm with a 10% outperformance of its regular index. All three ESG indices had even more vigor over the last year.

Chart 1

Measuring The Beat

Now that we know the ESG indices rode a wave higher, let’s look at how much more life they had than the regular indices. The last five years saw strong returns for equities in Canada and the U.S., and less so for EAFE, as shown in Chart 2. But the ESG indices performed the best. The orange bars show that the Canadian and U.S. ESG indices outperformed by more than 4% per year, while the EAFE ESG index outperformed by about 2%.

Chart 2

The big question is what have been the underlying causes behind the outperformance of ESG indices?

Root Causes

Research and experience should back your doctor’s advice. I strive for my blogs to combine market research and my experience as a practitioner. I spend a lot of time reading financial research, and while the data and formulas can get out of hand the results are worth the effort. Like a diagnosis, financial research can identify the underlying cause, or it can rule out what isn’t.

Some consistent answers to the underlying causes of ESG outperformance are provided by two recent research pieces[1]. The authors found that style factors are correlated with ESG scores. A fuller description of factors and factor investing is best left for another blog. For now, we just need to know that other extensive research has shown that there is a positive risk premium, or return, that has been earned for a stock’s exposure or correlation to factors such as value (low price to book value), small cap (small market capitalization), quality (low debt to equity or high return on equity), high price momentum, or low stock price volatility. These two studies showed that stocks with the highest ESG ratings have had strong positive exposure to quality, momentum, and low volatility factors and low exposure to value and small size factors.

Outperformance Diagnosis

So why is this exposure important? As I showed in previous blogs, up until recently value and small cap stocks have underperformed growth and larger cap stocks. The low exposure of highly rated ESG stocks to these two factors has therefore been a way of avoiding lower performing stocks. Companies involved in the fossil fuel industries have also performed poorly over the last five years. ESG Indices exclude these companies as they have low ESG ratings. The best performing stocks have been technology related and they have higher valuations, larger cap size, higher price momentum, and higher quality. They also have high ESG ratings so are a large part of ESG indices.

ESG Performance Prognosis

I don’t think we will see outperformance of ESG indices versus the regular indices over the next 5 years like we have seen over the last 5 years. However, it is reasonable to think that on a long-term horizon the best companies from a Sustainable Investing perspective will continue to perform well due to the avoidance of ESG risks, growth in demand for sustainable solutions and products, and reduced demand for ESG unfriendly products. But as always valuation is a key component. You need to be careful. Expectations and valuations for some highly rated ESG stocks are at very elevated levels.

The bottom line is that Sustainable Investing is not driven by looking for higher returns. It is driven by focusing on social values and helping to shape a better future. If you are trying to get the best of both worlds, consider this. Going forward the resurgence in the relative performance of small cap stocks and value stocks is likely to continue after such a long period of underperformance. Look to add companies to your portfolio that have exposure to those factors and have higher ESG ratings.

Invest Wisely,

David Schaffner, CFA

Principal, Wayfairer Capital Management

[1] Nicolas, R., “ESG Investing: Too Good to Be True?”  Enterprising Investor (blog), January 14, 2019 https://blogs.cfainstitute.org/investor/2019/01/14/esg-factor-investing-too-good-to-be-true/ and Madhavan, A., Sobczyk, A., and Ang A., “Toward ESG Alpha: Analyzing ESG Exposures through a Factor Lens”, Financial Analysts Journal, 77:1, 69-88.