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It is now widely accepted that the integration of environmental, social and governance (ESG) insights into investment decision-making at a minimum does not sacrifice performance. Analysis and studies from Morgan Stanley, Bank of America, Deutsche Bank, Harvard Business School, Oxford, MSCI, TIAA-CREF, and UBS, among others, point to this conclusion.

The most extensive review of academic research concluded that 90% of 2,200 individual studies found a non-negative relationship between ESG and corporate financial performance, and 63% showed positive findings.

There are also several studies that demonstrate that better management of ESG issues corresponds with a reduction in downside risk, lower cost of capital, lower loan and credit default swap spreads, and higher credit ratings. Credit ratings firms are now incorporating ESG due to its broad acceptance and relevance.

The volatile market response to the coronavirus pandemic demonstrated that ESG strategies provide downside protection. We conducted a review of ESG mutual funds and ETFs available on the Envestnet platform and found that these ESG strategies outperformed their non-ESG peers, across U.S. equity, international equity and fixed income, over both a four-month and 12-month period.

In the first quarter of 2020, 70% of sustainable equity funds finished in the top halves of their Morningstar categories, and 24 of 26 ESG-tilted index funds outperformed their closest conventional counterparts. BlackRock found that 94% of sustainable indexes outperformed during that time. Findings from MSCI and S&P found similar results.

It can be challenging to generalize performance studies. However, many of these findings have been noted as empirically well founded, and as historical data on ESG strategies becomes available for analysis through multiple market cycles, further research will be done on the topic.

Adding Value Across Approaches

There are a wide range of approaches to sustainable investing, including:

  • Negative screening for values alignment.
  • Integrating ESG factors into the investment process for risk mitigation.
  • Investing with a thematic focus on an area like climate change, diversity or water.

It is common for sustainable funds to incorporate a combination of these approaches. Frameworks also vary based on market, geography, industry and asset class.

Negative Screening

It’s widely believed that screening out “sin stocks,” like tobacco or weapons, results in portfolios that underperform. However, studies show that this is true only when you look at specific periods in time. Long term, the exclusion has an immaterial effect, if any. Jeremy Grantham found that excluding any sector from the S&P 500 from 1925-2017 resulted in a deviation of plus or minus 56 basis points on average. Essentially, it made no difference.

ESG Integration

The integration of material ESG factors into industry- and company-specific analysis, if executed well, can identify risks and opportunities that may not have been accounted for. Financial statements tell you less about a company’s situation today than they did 30 years ago. The intangible value of S&P 500 companies has shifted from 17% in 1975 to 84% in 2018. That means that 84% of the S&P 500 valuation is based on things like brand value, consumer perception, and customer and supplier relationships. That shift coincides with the emergence of the digital economy.

The five largest companies by market cap in 1975 were IBM, Exxon Mobil, Procter & Gamble, General Electric and 3M. In 2020, they are Apple, Microsoft, Amazon, Alphabet and Facebook. Evaluating intangible assets is more relevant than it’s ever been and presents a significant challenge.

ESG research and data leverages machine learning and natural language processing to measure these intangibles: consumer sentiment, reputation and brand value. We can also use this research to identify which companies are innovating in areas like climate solutions, water and waste technologies, and access to affordable housing and health care. Today, this data is essential to comprehensively evaluate companies.

Meeting Clients’ Financial and Non-Financial Goals

Despite compelling evidence to the contrary, the misconception persists that sustainable investment strategies underperform conventional ones. As further research dispels this myth, and acceptance of the value of ESG information becomes mainstream, advisors are now able to build portfolios that address their clients’ financial and non-financial goals, while performing in line with the market.

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Kiley Miller is an associate portfolio manager working with impact portfolios at Envestnet.