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ESG factors a welcome addition to portfolio management

The discussion of the merits of including environmental, social and governance factors in investment decisions seems to be over. Research suggests that correctly used they do not add to risk or hurt returns, and might add value.

As the research accumulates, more and more investment firms are incorporating ESG into their strategies, examining the environmental, social and corporate governance policies of the companies whose shares they might invest in and adding those factors to the criteria they use in choosing which stocks to buy. At the start of 2016, institutionally managed ESG assets totaled $8.7 trillion, according to data from the US SIF Foundation.

And more companies are publishing sustainability reports, showing how well they address environmental, social and governance issues. According to John Streur, CEO of Calvert Research and Management, more than 80% of the 500 largest companies now produce sustainability reports vs. less than 25% five years ago.

In addition, major investment management companies have joined the Sustainable Accounting Standards Board, which was founded in 2011 to develop accounting standards that help companies disclose material, decision-useful information about their sustainability efforts. The standards focus on topics that are reasonably likely to have material impacts on the financial condition or operating performance of companies in an industry.

Research by scholars at Harvard Business School found companies that perform well on material sustainability factors enjoy enhanced market returns over firms that perform poorly on these factors.

Among the companies represented on the SASB's investor advisory group are BlackRock (BLK), Capital Group, Pacific Investment Management Co., State Street Global Advisors, UBS and Vanguard. Other members include the California Public Employees' Retirement System, the California State Teachers' Retirement System and Ontario Teachers. The firms in the advisory group manage a combined $20 trillion in assets.

These investment institutions have come to accept that at least some ESG factors can affect the financial performance of corporations over the long term, and hence the stock performance, and want the material ESG factors more clearly disclosed in company regulatory filings and annual reports.

Since ESG investing first appeared as social investing during the struggle over apartheid in South Africa, with pension funds, endowments and foundations divesting of the stocks of companies doing business in or with South Africa because of the government's racial policies, many investors have been concerned that considering issues not directly linked to corporate profitability, and hence stock price, would harm portfolio performance.

The argument was that artificially restricting the universe of stocks by incorporating non-investment related issues, such as apartheid, increased the risk of the portfolio and potentially eliminated high-performing companies. Any reduction in potential return or increase in risk might place corporate pension funds in breach of the Employee Retirement Income Security Act since the returns were potentially being invested not solely in the interest of the beneficiaries.

The ERISA concern has been addressed in two ways.

First, ESG now involves more than eliminating companies whose products, policies or behavior are deemed not acceptable by those sponsoring the funds. It now focuses as much on the positive as the negative. That is, many ESG funds focus on companies that have taken positive steps to eliminate the negative externalities of their operations, e.g. carbon output, or are taking such steps. Others focus on investing in companies that have improved their corporate governance structures, such as diversifying their boards of directors and giving shareholders more say through their proxies. Where once many ESG investors automatically eliminated defense contractors, some are now being more selective, e.g. by not automatically eliminating companies that produce defensively oriented equipment, such as radar sets.

Second, research, particularly by MSCI Inc., shows that properly constructed portfolios can produce positive alpha. Zoltan Nagy, Altaf Kassam and Linda-Eling Lee backtested two ESG strategies over eight years from February 2007 through February 2015 — an ESG momentum strategy that overweighted stocks with improving ESG scores over time, and a simple ESG tilt strategy that bought stocks with high current ESG scores.

They found both strategies outperformed the MSCI World index over the time period. The momentum strategy performed consistently well through the sample period, while the tilt strategy saw roughly two-thirds of its outperformance come in the last two years of the period.

The SASB notes it is critical to success that investors be able to differentiate between material and non-material sustainability factors, but research found just 20% of the sustainability factors investors typically use are material by SASB standards.

Portfolios burdened by ESG factors that do not positively impact the financial condition or operating performance of the companies likely will underperform.

The question is: How long will the excess alpha of the portfolios built on companies with high ESG scores continue? It eventually should evaporate if most companies boost their ESG scores to the level of the current top-rated companies. But such a development is much to be desired as it would make the companies more efficient and better corporate citizens.