Socially responsible investing is getting big. In the U.S., investment assets taking some kind of socially responsible approach top $6.5 trillion. Globally, according to the Global Sustainable Investment Alliance, they make up 30% of institutionally managed assets, or $21.4 trillion.
Some big investors have been stepping up too. Norway’s sovereign wealth fund and Stanford are divesting from coal. The Rockefeller Brothers Fund is divesting from fossil fuels. Yale decided not to divest from fossil fuels, but its endowment head David Swensen sent a strongly worded letter to Yale’s external managers. He urged them to fully assess the greenhouse gas footprint of their potential investments and to avoid companies that don’t consider the costs of climate change.
Whether socially responsible investing can deliver good performance has been a longstanding question. Social responsibility and “environmental, social, and governance” or ESG approaches mean different things to different people. ESG issues go far beyond fossil fuels and climate change. They also embrace human rights issues, the health and welfare of employees, diversity policies, product safety, water and energy efficiency, and waste reduction. These are hard things to measure.
What’s more, there are different approaches to responsible investment. The most prevalent still is exclusionary screening – or removing certain kinds of companies like those with big carbon footprints or tobacco and alcohol producers. A second approach is to integrate ESG factors with traditional financial metrics when analyzing potential investments. A third is to use shareholder power to actively engage corporations to behave better. And finally, there is the positive approach, where one actively seeks out the companies with the best ESG practices.
One discouraging thing for ESG investors has been evidence that exclusionary screening hasn’t done particularly well. “Ethical” funds that shun tobacco, alcohol, and sometimes gaming and weapons have generally underperformed “sin stocks.” In fact, sin stocks like tobacco and alcohol have done remarkably well (see chart). It seems that when some investors shun tobacco stocks, they simply make them cheaper for others to step in and earn higher returns.
The better news for ESG investors is that the industry is moving beyond negative screening toward positive screening, which looks more promising.
A study by Robert Eccles, Ioannis Ioannou, and George Serafeim of the Harvard and London Business Schools found that using a positive approach can outperform. The researchers identified 90 “High Sustainability” companies that scored well on 27 ESG criteria and compared these to 90 “Low Sustainability” companies. The “High Sustainability” companies had higher stock returns and lower volatility over two decades (see chart).
All the 90 “High Sustainability” companies had actively pursued ESG goals since the early 1990s. They had a longer-term orientation than “Low Sustainability” companies. They were willing to make short-term sacrifices for long-term performance. They communicated more long-term information during analyst conference calls. And their stocks were more likely to be held by long-term investors.
It’s not surprising that companies with a long-term orientation do better than those focused on the next quarter’s results. But do companies with a long-term orientation pursue good ESG policies because it’s eventually good for business, or does a focus on ESG force longer-term thinking? The researchers posit that companies with strong ESG characteristics develop a long-term orientation because they make it a priority to build relationships with multiple stakeholders -- employees, customers, the community, and shareholders – and that takes time. Eventually those strong relationships become a valuable source of competitive advantage that translates into strong financial performance.