ESG investing — the practice of incorporating so-called nonfinancial factors such as environmental, social and governance issues into investment portfolios — has gotten a bit of a bad rap in terms of performance. But Matthew Sherwood, senior manager for public markets investments at the Ministers and Missionaries Benefit Board (MMBB), disputes the notion that ESG investments underperform their non-ESG counterparts, and now he’s got the numbers to prove it.
Sherwood, who is also a member of the investment committee and ESG working group for the Plan Sponsor Council of America and lectures on ESG investing at the King’s College in New York, recently coauthored a new paper on ESG equity strategies in emerging markets, which looked at the relative performance of the MSCI Emerging Markets ESG index versus non-ESG indexes. Sherwood found that institutional investors would have done better by investing in the emerging-markets ESG index, rather than its non-ESG counterpart, based on a 15 percent allocation of assets to emerging-markets equities from 2007 to 2016 (the average institutional investor allocation to emerging-markets equities, according to a 2015 survey from the Organization for Economic Cooperation and Development). The ESG-based index produced an annualized return of 2.69 percent over the period, while the non-ESG index returned 0.86 percent on an annualized basis. The overall portfolio return was increased by 0.4 percent annually with the use of the ESG index, compared with an increase of 0.13 percent annually if the non-ESG index had been used. For a $2 billion pension fund, that difference adds up quickly, amounting to a total of $5.49 million in assets over the nine-year period.
Sherwood says that not only was the ESG-based performance statistically meaningful and significantly greater over the same period than the non-ESG indexes return, it was also less volatile than the non-ESG index. He recently spoke with Matt Craig, global content director for Institutional Investor’s Investor Intelligence Network, about his findings.
Institutional Investor: How do U.S. investors stack up against their international counterparts when it comes to implementing ESG investment strategies?
Sherwood: U.S. investors are behind the curve on ESG issues. Many still only apply “sin stock” exclusions, avoiding investments in areas like tobacco, alcohol, gambling or pornography. Such a stand-alone, exclusion-based policy is an outdated way of looking at ESG investing, rather than looking at how ESG can add value for investors. ESG can be a positive force for investment outperformance, and it can also help investors understand companies, both as a research tool and as a risk management tool.
You are keen to see ESG factors integrated into the research and management of MMBB’s investment strategies. Why?
Over the long term (and everything else being equal), companies with a good ESG profile should increase in value above the market average. This result can be observed at an index level; the MSCI Emerging Markets ESG Index has been more attractive than the equivalent non-ESG index since its inception in terms of both risk and return. So, we can see how good ESG performance improves financial performance for stocks.
How is MMBB integrating ESG research into its investment processes?
We are looking for asset managers that incorporate ESG into their investment approach. We are not firing our managers who don’t take account of ESG, but we are looking for even small signs that it is an issue for them. For example, Do they take account of gender diversity at board level when they invest in a company?
You said that asset managers can be “all over the place” in their approach to ESG issues. In what way?
While negative screening, or exclusion-based investing, was the traditional use of ESG, additional dimensions of ESG investing have emerged, such as impact-driven, engagement-based, and integration-based. Sadly, in the current state the asset management community has not done a good job at producing sophisticated strategies for implementing ESG investing, and appears to use ESG as a marketing tool, rather than a mechanism for risk and research.
You have said that negative screening is an old-fashioned way of applying ESG beliefs, but there is a developing trend among large investors — and MMBB — to shun tobacco stocks. What do you make of this?
It is a product that kills off its customers, which doesn’t seem like a sound long-term investment proposition to me. Think about all the cigarette butts that filter into the water supply and sewers, creating carcinogenic waste. It is not just killing off its customers; there are other negative aspects to it. Institutional investors made a global commitment in the 1980s to unite in the fight against apartheid; tobacco exclusion is a similar cause, as drinking water is so important for all of us.
If tobacco ought to be excluded, where does that leave climate change–related companies?
I would exclude, say, dirty oil and fracking companies, but want to integrate some greener energy and natural gas producers. I would prefer to engage with companies that are proactively building their business model around reducing carbon usage.
How can ESG data be useful to investors?
In the same way that the equity options market gives you information on companies, so ESG can give insights into stocks. As such, ESG data provide significant cross-sectional information. I hope I can be a resource for other people, as the use of ESG by many investors still has some way to go.
