What are the choices and trade-offs investors face as they integrate ESG risks and opportunities into multi-asset portfolios? We decided to dig a little deeper in our 2022 Long Term Capital Market Assumptions.
In general, investors tend to consider ESG factors either to increase risk-adjusted returns (‘doing well’) or to achieve sustainable outcomes (‘doing good’). Our analysis finds no meaningful trade-off between doing good and doing well when investing in public markets.
An investor choosing to invest in a region’s equity or bond market will not face a total return or volatility penalty by incorporating ESG factors. As we assess the data, a sector-neutral equity portfolio is not hindered, relative to its benchmark, by a skew toward ESG leaders.
Asset class selection, ESG optimization
Tilting portfolios toward better ESG names in equities does not require sacrificing returns vs. a benchmark. Whether tilting portfolios toward ESG leaders can deliver sustainable alpha is a subject of spirited debate, with extensive research making the case both for and against.
There are two channels through which sustainable business practices can help companies outperform their peers and generate higher returns for investors. The first channel is market forces, where the costs of non-sustainable practices play out and can hurt a company, either because it suffers the effects of regulation or because it fails to meet consumer preferences. This market forces effect should be persistent through time.
The second channel is via increased demand, thus higher prices, for these companies’ shares relative to their lower scoring peers. This ‘repricing’ effect should be transient as market participants price in ESG considerations more accurately.
One common refrain about ESG investing is that it is simply “the quality factor in disguise” – and the performance characteristics of ESG investing reflect an exposure to quality stocks. A company with a strong management team is likely to be more profitable than its industry peers and also to have more robust governance arrangements. As a result, it would score better on traditional quality indicators such as return on equity (ROE) as well as on the ‘G’ of ESG. Similarly, companies with good human capital management practices may have a competitive advantage and higher ROEs, along with being more sustainable than their peers.
This overlap between ESG and the quality factor can be seen in the quality characteristics of the ESG portfolio data; the higher scoring ESG portfolio provides both higher profitability and somewhat lower volatility than the lower scoring ESG portfolio. It means that investors can ‘do good’ while also benefiting from any return potential that is associated with traditional indicators of quality.
Fixed income: An additional nuance
The rising availability of corporate ESG scores allows for robust assessments of corporate credit. Yet fixed income markets have lagged equities in the application of ESG criteria. This likely reflects a range of factors. Among them: Bondholders do not have any control rights; bonds may be issued by subsidiaries, for which it is more difficult to obtain relevant data; and the shorter maturity of corporate debt means that some long-term considerations are less financially material. Still, recent years have seen a very significant increase in the role of ESG in fixed income.
Sovereign bonds: Market participants are increasingly interested in assessing the sustainability characteristics of sovereigns. While there is abundant country-level ESG data, the challenge is what to do with this information. Countries with higher per capita incomes tend to have stronger institutional and regulatory structures and thus tend to score better on ESG metrics than developing nations.
Green bonds: Sustainable and ‘green’ bonds make up another market segment that has attracted rising interest. Such bonds increasingly trade at a systematic premium (‘greenium’) and thus a lower yield even when issued by the same entity. This most likely testifies to the strength of demand relative to supply. While yields will be relatively lower, total return could be bolstered by further repricing effects as demand for ESG instruments continues to grow. In addition, investors need to consider the potentially lower default risk of green bonds compared with bonds by other issuers.
Private market potential
The opportunity set should be as broad as possible, including private as well as public markets. It can be challenging to identify privately held ESG leaders—there’s no doubt about it. ESG information can be notably less transparent in private markets, requiring more research and investigation.
However, turning away from this arena could be a real loss. That’s because these markets increasingly provide portfolio solutions for attaining income, diversification and alpha. Finally, investment in private markets not only can help achieve return objectives – it’s also likely to be essential for achieving sustainable outcomes as private markets grow in size and importance.
To conclude, incorporating ESG considerations does not come at a financial cost unless investors reduce their opportunity set to assets whose ESG characteristics are easy to score and for which scores are readily available.
We see value in a two-step approach: choosing an optimal asset class mix based on traditional measures of risk and return, and tilting the portfolio toward ESG leaders or ‘improvers’ within each asset class.
