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The Relationship Between ESG and Financial Performance
By Will Linkenheil

Until quite recently, Sustainable, Responsible, Impact (SRI) investing was looked down upon by much of the investing community. There was serious concern "that incorporating environment, social, and governance (ESG) criteria into a portfolio design meant accepting a lower rate of return."

However, a growing body of research is making it "clear that sustainable and responsible investors do not have to pay more to align their investments with their values, or to avoid companies with poor environmental, social or governance practices."

Regardless of the perceptions of some investors, there is substantial support for the hypothesis that SRI investing does not impair, and perhaps even improves, financial performance. A study conducted by Tiburon Strategic Advisors found that "socially responsible investing and impact investing mutual funds met or exceeded median returns of traditional funds 64% of the time over the last seven years."

Several sessions on the agenda of the 27th annual SRI Conference in Denver, November 9–11, 2016, addressed the effects that responsible investment strategies have on portfolio performance.

A breakout session entitled Performance Methodology: Are We Asking the Right Questions? focused on the contributions that ESG factor analysis has on portfolio risks and returns. In this session, Jon Hale, PhD, Head of Sustainability Research at Morningstar, discussed the research that his team has done on this question. Among other things, Morningstar found that "the higher the sustainability rating, the lower the risk profile of the fund." Hale concluded that, on average, the reduction in risk attributed to strong ESG performance created higher risk adjusted returns for funds with stronger Morningstar Sustainability Ratings.

Stephen Freedman, PhD, Head of Thematic and Sustainable Investing Strategy for UBS Wealth Management Americas, discussed his meta-analysis of 51 independent studies. Freedman concluded that there is a "statistically significant positive correlation" between a fund being labeled as SRI and its financial returns. Whether it is a large firm like UBS, or a smaller one, most everyone now agrees that SRI has a neutral to positive affect on financial performance of investment portfolios.

Presentation of the Moskowitz Prize

There has also been an increase in academic research exploring SRI Investing. The Moskowitz Prize is "the only global award recognizing outstanding quantitative research in socially responsible investing" and it's awarded annually during The SRI Conference. Dr. Lisa Goldberg, Co-Director, Consortium for Data Analytics in Risk, and Adjunct Professor of Economics and Statistics at Berkeley's Hass School of Business, University of California, presented the 21st annual Moskowitz Prize.

Goldberg also led the breakout session going over the findings of the prize. She explained the research's findings on the relationship between a mutual fund's excess demand and the fund being SRI. The research found that SRI funds, especially those that are signatory to UN Principles of Responsible Investing (UNPRI), have "statistically significant excess demand" when compared to the average fund. As this analysis was performed on historical data, the conclusion is reminiscent of the fact that the total AUM of the SRI industry has increased by almost 1500% over the past 20 years.

MSCI Executive Director, Eric Fernald, moderated a session entitled ESG: Everyone Says "Give Us More Data" which focused on the "ever growing demand" for ESG data and the inherent challenges of performing ESG data analysis. Expert panelists discussed which ESG metrics are material to financial performance in great detail. The selection of which metrics to utilize for which industries has a large impact on investing decisions. With a plethora of data and metrics to choose from, a balance has to be struck between completeness and functionality. If a methodology incorporates too many metrics, the significance of the most important screens may be washed out.

The increase in both academic and practitioner research focused on SRI investing was evident during the 2016 SRI conference. Much of this research has been disproving negative myths associated with SRI investing. This has led to greater mainstream acceptance, which is a principle reason for the increased demand for SRI investing strategies and data used in ESG factor analysis.

You can tune in to the conversations that informed this blog by clicking on the session titles below:

First Affirmative understands that the ways we save, spend, and invest can dramatically influence both the fabric and consciousness of society. We believe that in addition to the benefits of ownership, investors bear responsibility for the impact our money has in the world. Are you making conscious decisions about the impact of your consumer purchase and investment decisions?

NOTE: Mention of specific companies or securities should not be considered an endorsement or a recommendation to buy or sell that security. Past performance is no guarantee of future results.

Posted: December 19, 2016