ESG investing is often dismissed as either a marketing exercise or a guaranteed drag on returns. In reality, performance outcomes depend far less on whether a portfolio is “ESG” and far more on how ESG is implemented.
Environmental, Social and Governance (ESG) investing provides investors with a framework for evaluating long-term risks and opportunities within investment portfolios. However, much of the discussion around ESG is clouded by marketing claims, misunderstandings and common misconceptions. Despite all the noise surrounding ESG investing, one thing is certain – the return dispersion of ESG investments differs greatly across styles and implementation. While ESG investing as a topic has largely been out of favour since markets sold off in 2022, it has been quietly mounting a comeback. For this reason, it’s essential that investors are able to decipher between different styles when constructing their own portfolios.
Different ESG styles
ESG considerations can be applied in a variety of ways depending on the required objectives, values and investment processes. Some approaches focus on avoiding certain activities, others on selecting companies with strong ESG characteristics. Meanwhile, some incorporate ESG factors into broader financial analysis and decision-making. As a result, two funds labelled as “ESG” can look very different in terms of holdings, risk profile and expected outcomes.
ESG screened
Often referred to as “light green”, ESG screened indices seek to improve the ESG characteristics of an index while limiting changes to its construction relative to the parent benchmark. For this analysis we will use the MSCI World, the primary benchmark for global equities. ESG screened indices seek to exclude companies based on controversial business activities and their CO2 emissions intensity. As a result, the MSCI World ESG Screened excludes around 8% of securities, with the number of constituents falling from roughly 1,320 to around 1,210. As a result, we see only a limited improvement in ESG characteristics, with the ESG rating as measured by MSCI rising from 6.6 to 6.7 (out of 10) and total revenues from controversial business activities fall from 2.9% down to 1.5%. Within that, we do see a significant reduction in CO2 intensity, which decreases from 95 to 64 as measured by tons per $1 million of revenues.
A stricter approach: Socially Responsible Investing (SRI)
Socially Responsible Investment (SRI) indices seek to go even further in improving ESG characteristics. Take the MSCI World SRI Low Carbon index as an example. Here, exclusions are based not only on controversial business activities and CO2 intensity but also the positive selection of companies with higher ESG ratings. This sees a material difference in index holdings, excluding around 71% of securities from the MSCI World. This means that the index falls to just 374 holdings – a huge change in the number of constituents. However, this material change in index construction leads to a significant improvement in ESG characteristics. With the MSCI ESG rating increasing to 8.1 (out of 10), the revenues from controversial business activities dropping to 0.2% and the CO2 intensity falling to just 19 tons per $1 million of revenues. A significant improvement over its parent benchmark and the ESG screened index.
What about ESG returns?
Ultimately the stricter the ESG selection criteria, the greater the deviation from the benchmark you can expect. Looking at the calendar year returns for the MSCI World (using the traditional index), ESG screened Index and the SRI variant (see graph above) it becomes clear that the return deviations between the traditional and ESG screened are significantly closer than that of the SRI index. Most importantly, and what may come as a surprise to many given its recent unpopularity, is that since 2021, the ESG screened index has outperformed its parent index in four of the last five years.
For the stricter SRI variant, the return deviations from the traditional benchmark are more pronounced, with returns last year at just under half those of the parent index. However, this works both ways, with significant positive outperformance of both comparison benchmarks in 2021 and 2023. Therefore, the improvement of ESG characteristics doesn’t just conclude that you will have lower returns but rather that you can expect returns to differ more significantly (both positively and negatively) as you increase the attempts to improve portfolio ESG characteristics,
Reviewing the investment
Understanding the underlying index exposure is important as certain sectors and regions can see the traditional index exhibiting ESG characteristics similar to its ESG variant. Therefore, funds must be assessed on a case-by-case basis and are dependent on which ESG criteria is being considered. This can inevitably become a trade-off. For example, in certain markets such as the UK, the underlying ESG characteristics of the index are poor due to sector exposures like defence, alcohol, tobacco, mining, as well as oil and gas. Here a stricter approach may be warranted in order to significantly improve upon traditional index’s poor ESG characteristics. Whereas the traditional MSCI Europe index already exhibits good ESG characteristics and therefore may not require you to take on the additional return deviations that come with a more focussed selection – as seen with SRI variant funds.
Final thoughts on ESG investing
As the data reveals, ESG investing is a complex topic with a lot of nuance for investors to decipher through. Contrary to popular belief, simply investing using an ESG strategy does not necessarily mean you can expect lower returns. Instead, data reveals that by taking a more nuanced view on ESG investing, you can look to improve your portfolio’s ESG characteristics and also seek to reduce the deviation from the traditional market return. While ESG may have taken a back seat in the last few years, it’s performance as of late shows that it remains a relevant consideration in investment portfolios.
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This article is for general information purposes only and does not constitute financial advice or a personal recommendation. Past performance is not a reliable indicator of future results. Investments can rise or fall in value, and you may receive less than you originally invested. Tax treatment depends on individual circumstances and may change in the future.
