The California Public Employees’ Retirement System recently opened a new chapter in socially responsible investing (also known as environment, social and governance, or ESG, investing) when its investment committee decided to start requiring that the boards of the companies it invests in include climate change experts.
With this move, Calpers is attempting to turn ESG investing on its head. Rather than divest from companies it deems undesirable, it will engage those companies and attempt to improve them from the inside.
Which begs the question: What’s causing Calpers to rethink the traditional levers of ESG investing?
ESG investing is intuitively appealing from an ethical perspective, and also from a financial perspective. Some companies are clearly better citizens than others, and it’s reasonable to assume that our collective well-being would be improved by having more of the good ones and less of the bad ones. (Though the standards and metrics around deciding what’s “good” or “bad” can be a decidedly subjective affair, of course.)
It’s also reasonable to assume that companies that are serious about corporate governance and environmental and social impact are less likely to encounter costly surprises that inevitably drag down stock prices (for what can go horribly, horribly wrong, see BP’s Deepwater Horizon oil spill).
There’s just one small fly in the ointment: Companies with stellar ESG ratings have underperformed the broader market, and exposed investors to higher risk to boot. The MSCI World ESG Index returned 9.8% annually from May 2009 to February 2016, with a standard deviation of 14.5% (the longest period for which data is available; those returns include dividends). By comparison, the MSCI World Index returned 11.3% annually over the same period, with a standard deviation of 14.4%. (Standard deviation reflects the performance volatility of an investment; a lower standard deviation indicates a less bumpy ride.)
To see whether the ESG Index’s performance is indicative of investors’ experience with ESG investing more broadly, I gathered performance data for every equity mutual fund with a Morningstar ESG rating. I then sorted the funds into five groups based on their percent of assets under management with high ESG scores, as reported by Morningstar.