Interest in sustainable investing and socially responsible investing continues to grow, experts say. According to the Forum for Sustainable and Responsible Investment, 720 funds classified with an environmental, social and governance (or ESG) focus held $1 trillion of assets at year-end 2012.

That’s a 78% increase from the $202 billion held by 260 funds at year-end 2010. If your clients aren’t already asking about sustainable investing, there’s a good chance they will be soon.

The terminology involved with sustainability and sustainable investing can be confusing. Beyond the ESF classification are other definitions that expand the concept of sustainability to include a wider range of organizational behaviors.

The terms “socially responsible investing” and “responsible investing,” for example, are also used to describe investment management approaches that incorporate ESG analyses. Despite the nomenclature proliferation, the approaches generally agree on the need for companies to both avoid doing harm—i.e., avoid environmental disasters—and to promote positive environmental change.

Corporate Values

Sustainability concerns are global in their reach. Brazilian power company Cemig (CIG), for instance, manages the largest electric energy distribution network in Latin America, which is one of the four largest such networks in the world. Cemig’s sustainability efforts date back to the early 1960s, says Luiz Augusto Barcellos Almeida, head of corporate sustainability.

The company’s first large-scale hydroelectric plant, built in 1962, incorporated Brazil’s first multiple-use reservoir. In addition to providing electricity generation, the plant made the river navigable and controlled floods, benefiting the entire population of the São Francisco River valley in the northern area of Minas Gerais.

The theme of climate change has been a formal part of Cemig’s strategy since 2012. Among other initiatives, the company has committed to the following priorities: the generation of electricity from renewable sources, implementation of conservation and electricity efficiency projects, investment in new energy sources, assessment of the risks and opportunities of climate change, and improvement in process efficiency, technology and innovation programs.

Cemig’s sustainability efforts have brought it recognition. The company was first included in the Dow Jones Sustainability Index in 2000, Almeida notes and has been included every subsequent year. It is the only Latin American electricity-sector company to be part of the index since its launch.

Comparable Performance

Investors are unlikely to argue against corporations pursuing sustainability unless, of course, that effort has a detrimental impact on investor returns or increases risk. It’s a trade-off: How much return (or risk) are investors willing to give up (or take on) to support a company with sustainability and other ESG practices that support their values?

Research focusing on sustainability as an investment strategy suggests that the “return or values” question is a false dichotomy. TIAA-CREF quantitative portfolio managers Lei Lao, CFA, and Jim Campagna, CFA, recently considered the return and risk performance of several leading socially responsible investing (SRI) equity indexes. They published their results in recent white paper, “Socially Responsible Investing: Delivering Competitive Performance.”

The authors selected five widely known U.S. equity SRI indexes with track records of at least 10 years: the Calvert Social Index, Dow Jones Sustainability U.S. Index (DJSI U.S.), FTSE4Good U.S. Index, MSCI KLD 400 Social Index and MSCI USA IMI ESG Index. They then compared the indexes’ returns with those of the Russell 3000 and the S&P 500 indexes. They also calculated volatility measures and Sharpe ratios to understand risk-adjusted results.

“Finally, we compared index returns with [their] respective benchmarks to determine tracking error rates. We also sought to determine whether differences in results were statistically significant or caused by random variation,” the experts explained.

The result supports the case for SRI: “… [O]ur analysis found no statistical difference in SRI index returns compared to [those of] the two broad market benchmarks. In other words, SRI can achieve comparable performance over the long term without additional risk, despite using a smaller universe of securities meeting ESG criteria.”

Specifically, returns for the SRI indexes were “similar to each other and compared to [those of] the broad market. Ten-year average annual performance for the five U.S. SRI indexes ranged from 7.87% to 6.42% vs. 7.78% and 8.23% for the S&P 500 and Russell 3000 indexes, respectively. The gap between best and worst average annual performance spanned 145 basis points.”

In terms of risk, the authors found that the SRI index returns’ standard deviations were similar to those of the S&P 500 and Russell 3000 indexes:

  • The average annualized standard deviations for the SRI indexes ranged from 15.4% to 17.03% over the past 10 years, compared to 16.36% and 16.96% for the S&P 500 and Russell 3000, respectively.

  • The spreads between standard deviations for SRI indexes and their benchmarks averaged only 30 basis points for the 10-year period.

  • Even though some standard deviations topped 40% during the 2008–2009 market collapse, the maximum spread between SRI indexes and their benchmarks averaged only 1.83% for the 10-year period.

The SRI indexes’ risk-adjusted returns also tracked the broad market indexes: “Sharpe ratios, or returns per unit of risk, also tracked fairly closely over various time periods, with average SRI index Sharpe ratios mirroring the underlying market or lagging only slightly,” according to the analysis.

Value & Values

Other researches have reached similar conclusions on SRI’s benefits. Indrani De, CFA, and Michelle Clayman, CFA, with New Amsterdam Partners LLC in New York recently published “The Benefits of Socially Responsible Investing: An Active Manager’s Perspective.” This was the firm’s second investigation of ESG-investing’s impact on risk and returns, and it was motivated by the firm’s work as managers of ESG and non-ESG portfolios.

Their study took a different approach than that of TIAA-CREF. The authors restricted the investible universe by deleting the stocks of companies with the lowest ESG scores. “We found that restricting the investible universe through deletion of the worst ESG stocks tends to improve the probability distribution of returns with a higher average and maximum portfolio return,” they explained.

Using risk-adjusted returns as the variable of interest (instead of returns) in the random selection from the restricted and unrestricted universe led to similar conclusions, they noted: “We conclude that excluding the worst ESG stocks from the investible universe tends to improve the return and risk-adjusted return distribution even through a process of random selection.”

There are two reasons to think about ESG when investing, says Clayman—value and values. Plus, there are two considerations on the value side—alpha and risk. The alpha perspective is that companies with positive ESG profiles tend to outperform average or below-average ESG profile companies. On the risk side, you can have a company that looks great on paper but presents significant tail risk; ESG profiles can help identify those companies. She cites the large fines imposed on energy company BP as an example of this risk.

For values, Clayman asks, why shouldn’t investors’ portfolios reflect their personal values? Her firm’s research indicates that investors can incorporate their values, whether faith based, environmentally based or based on another social metric, without having to sacrifice returns.

Joy Facos, senior sustainable investing research analyst with Sentinel Financial Services Company in Montpelier, Vermont, also points to the risks that low-rated ESG-companies can pose. Companies without strong environment protection practices or health and safety practices are more likely to be saddled with costly accidents and litigation that can damage their reputation. When companies don’t take these practices seriously or view them as an important element of risk management, she says, it can hurt the company’s performance in the long term.

Varied Investment Strategies

Socially responsible investing started with an exclusionary approach: no tobacco companies, weapons manufacturers, gaming businesses and so on. Today, that approach is often supplemented by goals-oriented investing that can yield powerful results. Sentinel Investments, for example, combines these traditional exclusionary screens with qualitative screens that consider business practices, corporate governances and more, such as having exceptional environmental policies, meeting or exceeding industry standards, and taking proactive approaches to environmental initiatives.