While now prevalent across most asset classes, responsible investing remains dogged by misconception. Many asset management practitioners still believe there is a performance cost when considering ESG issues. 

Contesting this belief is a growing body of academic evidence, which supports the view that considering material ESG risks is beneficial from a performance and risk perspective. A recent paper1 from UBS investigating academic research, suggesting performance and risk characteristics of ESG-based equity strategies are potential sources of alpha, was telling.

The paper’s findings not only supported the academic view that equities with high ESG rankings can outperform the broader equity market, but “tilting” a high-quality portfolio in favour of the highest ranking or improvement in ranking (momentum) enhanced returns further. In terms of risk, all three strategies evaluated achieved better risk-adjusted returns. 

Moreover, when we consider the academic evidence on the positive impact of integrating ESG analysis in other areas, such as cost of capital reflecting quality and risks at the corporation level, it reinforces our conviction that considering these factors can be beneficial to active equity strategies.

However, we believe it is vital to question the subjectivity of a company’s ESG rating. Index providers have not wasted time in grasping the market opportunity for ESG-related indexes and ratings to differentiate between the “good” and the “bad”. Subsequently, the indices have been readily accepted as a convenient way to benchmark the active manager, and have created new product opportunities for passive index-tracking products. 

However, it is not widely acknowledged that academic studies highlight inconsistencies and weak correlations between the different rating providers. This problem is likely explained by the subjectiveness of attaching materiality and hence weightings to the many factors considered within an ESG rating. The indices themselves also likely contain various factor biases (such as market capitalisation) that investors would be wise to understand from a risk perspective.

From an investor’s perspective, integrating the consideration of a company’s ESG risks and opportunities into the process of stock selection appears the most prudent solution to the judgement of materiality. Rather than relying on a questionable third party opinion, a traditional fundamental approach to equity research and analysis can be enhanced by looking through the lenses of E, S and G. Subtly different from traditional analysis, these lenses are qualitative and quantitative. 

This approach requires analysts and portfolio managers to ask an additional set of questions of the companies they invest in. This is a key tenet of responsible investing: the importance of engagement. As investors demand higher ESG standards, it is incumbent on them to communicate standards to company management and monitor responses. 

Ultimately, the threat of divestment will only strengthen as the weight of assets managed responsibly increases. Simply avoiding the “worst-in-class” should benefit active management and send a powerful message. Better still, performance can be enhanced by short selling the worst companies, an activity that increases cost of capital and dis-incentivises irresponsible behaviour. 

Momentum behind responsible investment is driven by client demand, as this approach resonates with changing client values. This shift clearly continues to surprise many in our industry. This is evident in all investor age groups; it’s not simply a “millennial” issue. Investment managers that fully integrate the consideration of ESG issues into their investment philosophies will, like an electric vehicle, quietly but rapidly overtake those with their heads firmly stuck in the coal pile.


1. Quantitative Monographs – Exploring ESG Investing, UBS Global Quantitative Research, 13 December 2017