By Hashmeel Suka.
In the last decade or so, environmental, social and governance (ESG) factors have become an important consideration in the investment decision-making process. By extension, it has also become more important for companies to have a focused and clear approach in addressing ESG issues and risks. ESG factors encompass how companies contribute to the conservation of the natural world, what impact is made on people and society, as well as what business standards and practices are used. Essentially, this is driving companies toward enhancing value for all stakeholders involved and not just shareholders alone. It has been reasoned that placing a stronger emphasis on ESG matters may in fact also translate into better returns to shareholders. Some of the arguments to support this view include:
It follows that these factors can improve company profitability, valuations, and consequently, share price returns.
Mixed fortunes
In the South African context, the past ten years shows that the investment performance of companies with a stronger focus on ESG factors has been mixed. The JSE All Share index underperformed its comparative ESG benchmark between 2015 and mid-2021, but then outperformed this benchmark thereafter.
A recent academic study showed no real benefits (i.e., alpha) when it came to ESG investing locally. Heerabhai (2022) examined the effect of ESG ratings on the financial performance of firms in South Africa, using both regression and portfolio analysis. The study took a sample of 88 firms listed on the JSE for which ESG ratings (per Bloomberg methodology) were available consistently, corresponding to a six-year time period between 2013 and 2019. Firms were then ranked according to their ESG scores and placed into distinctive portfolios (e.g., those with high ESG-ratings and low ESG-ratings), which were tested against an equally weighted benchmark of the same universe of stocks. The study ultimately showed that over the time period, investments with a particular focus on ESG led to no significant financial advantage at a portfolio level.
From an international point-of-view, we see quite contrasting results. The S&P500 and the Nifty 50 have consistently outperformed the MSCI ESG benchmark over the period, while other indices (or markets) have underperformed the benchmark, with the Hang Seng and ASX showing notable weakness.
Possible explanations for mixed outcomes
1) There are a myriad of providers of ESG scores, with methodological divergence and potential flaws in the way ESG scores are calculated.
2) Proponents of the efficient market hypothesis argue that a valid explanation for the varying results is that information about ESG factors is already reflected in share prices and hence investors should not be compensated (or accordingly disadvantaged) for overweighting or underweighting any ESG factors.
3) Interest and support in ESG investing has faded. From 2015 there was significant growth in ESG investing. According to a study done by the Global Sustainable Investment Alliance (GSIA), assets under management (AUM) within the ESG market amounted to ~$22.8 trillion in 2016, grew to ~$30.7 trillion in 2018 and eventually reached a peak of ~$35.3 trillion in 2020. In the 2022 review of the study, it showed that the global market for sustainable assets had shrunk to ~$30.3 trillion in that year. This contraction in ESG flows has been markedly evident in the US, where several asset managers noted a sharp decline in ESG-related AUM. Some of the reasons for this was purported to be general market weakness (amid a tough economic environment) as well as a decline in confidence about the benefits, and some concerns about the risks, of ESG investing.
4) Investor attention being diverted elsewhere. Following years of "easy" market conditions, it has become more difficult to navigate risk in global markets. Between Covid-19, high inflation, rising interest rates, several major wars, the AI boom and political distractions, investors may have lost focus on company specific ESG issues.
Is there still an argument to be made for sticking with ESG?
The above reasons are all legitimate concerns when deciding on whether it is still worthwhile to invest in ESG funds or assets. But, aside from the efficient market hypothesis argument (which would suggest investors just buy a market fund anyway) most of the current concerns around the ESG space can be addressed.
Scoring methodology is becoming more advanced and will be pushed to convergence over time. ESG investing is a relatively new phenomenon, and it can take the market a long time to find consensus on how to approach a concept that is as vast and complicated as ESG. Our suggestion would be to take a more nuanced approach to ESG investing for the time being - perhaps by focusing on specific sectors like new energy and clean water or identifying companies that truly strive to become sustainable and are future-focused.
In terms of investor interest, it may be a cyclical phenomenon where macroeconomic conditions and widespread uncertainty from a geopolitical and political perspective will keep investors at bay until the situation stabilises or improves. Taking a longer-term view, we will happily still back companies and sectors that demonstrate broader stakeholder considerations and good governance, as opposed to those operating extractive and damaging business models or who show little regard to corporate best practice. While returns may not be linear, these companies will likely have more longevity, lower volatility, and carry lower financial and operational risk over time.
Finally, investors can use ESG strategies to attain greater non-financial utility (like happiness and comfort) as opposed to traditional ones. Being invested in companies and sectors that are working to "make the world a better place" may align better to your personal values and could support, at the very least, "a feeling" of taking less risk.
