Returns of ESG & Impact Investments: A Comprehensive Assessment

Introduction

ESG (Environmental, Social, and Governance) and impact investments have gained significant attention in recent years as investors seek to align their financial goals with sustainability and societal impact. This blog post aims to assess the returns of ESG and impact investments based on various research papers, industry insights, and market trends. By exploring the connections between ESG factors and financial performance, we can gain a better understanding of the potential benefits and challenges associated with these investment approaches.

ESG Factors and Returns: Research Insights

Numerous research studies have examined the relationship between ESG factors and investment returns. The PRI (Principles for Responsible Investment) blog provides a review of industry research on this topic. It highlights the challenge of quantifying climate risk and the varying correlation between governance-related factors and risk-adjusted returns across different regions. Additionally, research has expanded beyond equities to include corporate credit, sovereign debt, and alternative markets. Energy exposure has been identified as a key influence on performance, with higher ESG rankings providing more resilient relative returns during periods of market volatility. The integration of ESG factors in investment outlooks is a growing trend, signalling the increasing importance of responsible investment.

A study mentioned by PRI indicates that incorporating ESG factors can lead to lower volatility in stock performance compared to industry peers, challenging the conventional belief that less risk results in lower returns. The study analyses 12 industries and finds that ESG factors affect each industry differently, with potential risk mitigation in the energy sector. ESG companies demonstrate better returns in several industries, with a positive effect averaging 6.12% across all industries. This study suggests that ESG practices can reduce risk and potentially enhance financial performance.

Correlations between ESG rankings and risk-adjusted equity returns have been observed, but the causal factors behind these correlations are less developed. Various factors such as market capitalization, industry sector, and ranking changes influence the relationship between ESG rankings and equity performance. Furthermore, the concept of economic moat, which relates to competitive advantages, has been linked to ESG rankings. Combining economic moat analysis with ESG factors could potentially lead to improved risk-adjusted returns.

ESG Integration and Impact Investing

ESG and impact investing have gained traction, prompting businesses to reconsider their strategies and asset managers to incorporate ethical considerations. ESG integration strategies vary by region and asset size, leading to an increase in requests for ESG proposals. Impact investing, which focuses on generating tangible social and environmental benefits, has become a market valued at around $715 billion. The integration of ESG factors allows businesses to address societal and environmental challenges while generating profits. Investors are increasingly incorporating ESG considerations into their investment analysis to align their portfolios with sustainability goals.

Performance of ESG Factors and Impact Investing

ESG factor returns in 2022 remained positive, although lower than the previous five years. Companies in the top ESG quintile consistently outperformed those in the bottom quintile across various time periods within the MSCI ACWI Investable Market Index. Higher ESG scores were associated with lower stock-specific drawdown risk and slightly better earnings growth and stock performance. Sector performance across global equity markets saw a rotation, with energy outperforming while technology and communication services underperformed. However, it is important to note that the performance of ESG factors varies across sectors and regions, emphasising the significance of time horizons and industry-specific analysis.

ESG Rating Disagreement and Stock Returns

ESG ratings provided by different agencies can exhibit significant disagreement, impacting stock returns and capital costs. Disagreement is influenced by firm characteristics and varies across industries. The study suggests that high disagreement in environmental ratings is associated with higher future appraisal volatility, while high disagreement in social ratings is associated with higher future stock returns. These findings highlight the importance of conducting thorough research and due diligence when assessing ESG ratings and considering their impact on investment decisions.

Challenges and Limitations

While there is growing evidence suggesting a positive correlation between ESG factors and financial performance, it is important to acknowledge the challenges and limitations in this field. Some of the key challenges include:

• Lack of standardised metrics: There is a lack of universally accepted and standardised metrics for measuring ESG performance. This makes it difficult to compare and evaluate companies consistently across different industries and regions.
• Data quality and availability: Access to reliable and comprehensive ESG data can be a challenge. Companies may have varying levels of disclosure and transparency regarding their ESG practices, making it challenging for investors to obtain accurate information.
• Time horizons and short-term market dynamics: ESG factors may not always have an immediate impact on financial performance. Short-term market fluctuations and investor sentiment can overshadow the long-term benefits of ESG integration, making it important to consider the appropriate time horizons for evaluating returns.
• Attribution of performance: It can be difficult to determine the direct causal relationship between ESG factors and financial performance. Other external factors, such as market conditions, industry trends, and company-specific variables, can influence investment returns.

Despite these challenges, the growing interest in ESG and impact investments indicates a shift in investor preferences towards sustainable and responsible investing. Institutional investors, asset managers, and individual investors are increasingly recognizing the potential benefits of integrating ESG factors into their investment strategies.

Conclusion

ESG and impact investments have gained momentum in recent years, with growing evidence suggesting a positive correlation between ESG factors and financial performance. Incorporating ESG considerations can potentially lead to lower volatility, risk mitigation, and enhanced risk-adjusted returns. However, it is important to consider the limitations and challenges associated with ESG investing, such as the lack of standardised metrics and data quality issues.

As the field of sustainable investing continues to evolve, it is crucial for investors to conduct thorough research, engage in active due diligence, and seek reliable sources of ESG data. By aligning investment goals with sustainability and societal impact, investors can contribute to positive change while aiming for competitive financial returns.

Lead Author:

Lan Nguyen
Co-Founder, Head of Science & Policy
Email: lan.nguyen@nuoa.io

Ms. Lan Nguyen does her PhD research in Economics, Environment, Evolution, and Ecology at the prestigious Dartmouth College (USA). Her research focuses on green growth policy, natural resource management, and environment policy and ecology

Co-Author:
Long Pho
Business Analyst – Nuoa.io
Email: long.pho@nuoa.io