ESG stands for environmental, social, and (corporate) governance. These are three broad areas or categories of interest for socially and environmentally responsible investors.
Such investors are those who value the incorporation of their concerns and values, such as environmental sustainability, into their choice of investments.
This is contrary to many other investors who only consider the potential risk and/or profitability of mutual funds or ETFs (exchange-traded funds) they invest in.
Critics of ESG investments dismiss this form of investing as a mere feel-good strategy that is unrelated to the performance of the investment.
They argue against this type of investment strategy because they feel assets with environmental, social, and corporate governance criteria cannot be compared with non-ESG stocks in terms of high returns.
But is this true? We’ll see that in a bit.
Do ESG Investments Outperform the Market?
More than enough facts show that ESG investments outperform and will continue to remain popular, especially among young investors.
Here is how ESG investment outperformance comes about.
Responsible investing contributes to the improvement of risk-adjusted returns.
Integrating ESG criteria into the investment selections and the process can be termed as responsible investing that will potentially enhance performance. And, performance should be seen from a broad perspective to mean positive societal contribution and higher financial returns.
ESG investment returns are higher because ESG integration has a positive impact on risk-adjusted returns, especially in the longer term. Consistent and continuous ESG integration contributes to unlocking a firm’s potential value.
Also, the integration helps investors and investment managers to identify investment opportunities and associated risks.
This is in addition to ESG strategies having a positive impact on the well-being of the environment and society.
Do ESG Investments Outperform the Market because they are Popular?
This is what critics would want you to believe. However, it is not true that ESG investments necessarily rank high on the popularity index.
Indeed, the quick and accurate identification of investment risks is enabled by ESG integration.
The ability to identify risks supports smart investment decisions and the avoidance of investments that will potentially yield losses.
Also, the identification of investment opportunities contributes to a diversified investment base where investment returns can accrue from multiple portfolios.
Furthermore, the deepened understanding of a firm’s business ambitions and strategies that is made possible through ESG integration contributes to ESG investing outperformance. Investment decisions should be based on strong foresight and understanding of strategy and a company’s true ambitions.
Understanding a company’s ambitions and strategy is critical to completing a thorough and full financial analysis of the company.
All these contribute to informed decision-making on the part of investors and investment managers.
See Related: Truist Financial Corporation ESG Profile (TFC): Is It Sustainable?
Are ESG Investments the New Dawn?
Elsewhere, available data provide an answer to the question: Do ESG investments outperform the market?
Data reveals that ESG investments are the new dawn. A 2021 report by Fidelity International has established that there is a strong relationship between ESG quality and dividend growth.
The report’s findings indicate that firms that possess a strong rating on sustainability have recorded the highest levels of dividend growth over the years. This stands at more than 5 percent in the past half-decade.
The situation has been different for non-ESG companies whose sustainability ratings are weak. The report findings show that this category of companies has offered the lowest average dividend growth levels in the past five years.
This is good news for investors focused on ESG performance. The stronger the sustainability ratings, the higher dividend growth levels in the long term.
ESG integration does not only contribute to higher dividend growth. There is widespread evidence showing that, in the long run, sustainable policies create more and better value for companies. The value created contributes to higher sustainable funds performance that outstrips that of non-ESG funds or stocks.
Energy companies illustrate this very well. Those companies focused on the exploitation of fossil fuels would continue investing in infrastructure and drilling capabilities.
These companies will also plow back profits to fund their green energy transition by investing in their capabilities. Effectively, this will result in reduced dividends payable to investors.
However, green energy firms that adapt to renewable energy and new power generation forms will be excellently placed to succeed in a green energy dispensation.
This is because of additional value created by integrating the environmental aspect of ESG criteria.
See Related: Best Fuel Free Funds for ESG Investing
ESG Investing Outperformance Relative to the Market
So, why do ESG investments outperform?
It is not just the transition into green energy and other responsible investment decisions that contributes to higher ESG investment returns. Here is why ESG investments Outperform.
1. Low Associated Risk
One reason for the outperformance is the low risk associated with ESG investments.
Indeed, there is a strong correlation between growth and low ESG risk. This helps companies avoid litigation, higher regulatory costs, stranded assets, and brand erosion. Higher regulatory costs can cut into a company’s earnings resulting in depressed dividend performance.
Also, brand erosion can be a big contributor to a fall in stock performance and market capitalization. Moreover, a company that is registering higher performance has a highly developed supply chain that can offload assets and grow its earnings. Stranded assets, regulatory costs, and brand erosion, litigation can be costly for companies.
It is fulfilling for investors that ESG integration will contribute to low risk and the avoidance of the various business challenges.
See Related: Reasons Why ESG Investing is Important
2. ESG Investments are Safe
The strong governance that is part of ESG integration contributes to downside risk protection, which in return safeguards the profits. Strong governance means a company is well run by those on whom the leadership and governance roles are bestowed upon in the company.
Companies can only continue registering profits if they have a strong corporate governance practice. This embeds trust among core stakeholders such as the shareholders, suppliers, employees, and customers.
Also, strong corporate governance practices help avoid destructive situations such as embezzlement of funds and outright corruption. These are issues that can sound a death knell for companies.
Also, well-run companies are the pride of employees and help attract talent and avoid employee turnover. All these contribute to strong performance and protection of profits.
A global transition to sustainability has significantly influenced ESG performance. Owing to global issues such as global warming and climate change, ESG will continue to take center stage in the operation of companies.
The so-called financial parameters have gained prominence in how corporate performance is assessed. This has cultivated a need to integrate these parameters in companies, and this is something that investors can identify with.
See Related: 8 Best ESG Investing Courses to Take Today
3. Impact on Long-term Financial Performance and Corporate Strategy
ESG investing outperformance is likely to continue. This is because ESG integration is going to have a bigger impact on long-term corporate financial performance. The focus on environmental, social, and governance parameters, as it is the reality now and will be in the future, will necessitate additional investments.
Governments and corporates are and will be more stimulated to pursue sustainable allocation of capital to projects. This enables companies to avoid a situation of high volumes of sunk costs and low-return investments.
Furthermore, the focus on ESG will help governments and companies make requisite changes to governance and policy structures necessary to realize the desired governance practices and implementable policies. All these efforts and focus on ESG integration are what support the outperformance of ESG affiliated investments
4. The Strong Resilience
Higher than normal ESG performance is also supported by strong resilience, a product of implementing ESG criteria. ESG-integrated strategies that companies implement make them resilient and withstand any crises that may come their way.
The management of crises ensures that companies can weather the market turmoil. This has been made clear, especially during the Covid-19 pandemic that has battered companies and global economic performance. NN investment partners report that many “sustainable investment solutions outperformed their traditional peers.”
In addition, investment solutions that are focused on sustainability experienced fewer withdrawals even when markets fell. This confirms that sustainable investment products are more resilient and can withstand storms, and register higher returns in the long run.
5. Resilient and Responsible Business Plans
Available evidence shows that companies that are focused on contributing towards a sustainable society and planet, and that take a long-term investment view, craft resilient and responsible business plans.
Such firms avoid opportunistic behavior and focus on short-term gains. The crafting of resilient and sustainable business plans increases investor interest in investment strategies that are founded on sustainability.
Crises such as the Covid-19 pandemic expose the absence of resilience among companies. The firms that have focused on providing the whole package of people, planet, and profits seek to benefit stakeholders more and display longer-term resilience.
Customers are also more drawn to companies that seriously incorporate governance and social factors in their practices during a crisis. This has been evidenced during the pandemic.
Companies focused on supporting employees, customers, and communities during crises have their corporate citizenship profile elevated. This makes them attractive to a huge number of stakeholders.
Consequently, this boosts ESG performance because of the increased interest among investors in the companies’ investment portfolios. Furthermore, the companies are rewarded by investors, and this cultivates higher investment performance.
See Related: Best Investments for Young Adults
6. The Shift in Investment Behavior Favors ESG Investments
Sustainable behavior has taken a global dimension. This means that more institutions and individuals want or are focused on selecting investments based on their priorities and values. The financial benefit is no longer the only motivator influencing investment decisions.
This shift immensely contributes to the high demand for and uptake of ESG-integrated products. More products and investment vehicles are being developed to meet the investors’ demand, meaning that companies can register better financial performance. This is how ESG investing outperformance is being realized.
As investors become more aware of ESG factors, they can engage in more responsible investing. This no longer involves blatantly excluding industries and companies that engage in negative behavior and activities such as pollution and exploitation of workers.
The currently available ESG information is more in-depth and broader. This allows investors to look wholesomely at ESG factors and settle on investment portfolios that are in tune with their priorities and values.
Adhering to this process helps investors to invest holistically, and the approach generates higher financial returns after adjusting for risk.
ESG’s strategy in investing is a complete approach to financial or property investing and is coupled with responsible investing.
See Related: 13 Best Sustainable Robo-Advisors for SRI & ESG
7. ESG Investments Perform better because of the Long-term Focus
The investment that happens over the long term is also able to generate stable returns.
Researchers at Morningstar established that funds focused on sustainable investing have higher survivorship rates compared to non-ESG funds. Firms that invest in aspects such as the environment, employees, and excellent corporate governance realize benefits in the long term.
For example, investing in environmental sustainability is not expected to contribute to short-term financial gains. Instead, such investments yield positive financial performance in the long term. Similarly, ESG investment outperforms the market in the long term because of the compounding effect.
Furthermore, long-term ESG plans communicated by the management of companies generate positive reactions. The positive reactions translate into investment decisions that ultimately yield returns in the long term.
ESG investment returns are higher in places such as Europe as compared to the United States. This is because European investors prefer investing more in ESG stocks. After all, they consider this as an ethical investing practice.
This ultimately drives the stocks prices up. As prices of stocks go up because of the high demand for ESG investment vehicles, the valuation of individual and institutional stocks increases. And this benefits investors.
Therefore, ESG investments outperform the investment market in Europe. This is a wave that is expected to catch up in the US as more investors become aware of ESG-focused investment practices.
See Related: Shareholder vs Stakeholder: What’s the Difference?
Evidence that ESG Investments Outperform the Market
1. Academic Research
Academic research can also help us answer the question: Do ESG investments outperform the market?
Research reveals that companies that behave responsibly and focus more on improving their ESG integration register better financial performance.
ESG investment returns are higher because ESG factors impact the longer-term sustainability of a firm’s business model. This, in turn, affects the future profitability of a company.
Accounting for material ESG factors ensures that investment assessments are better and more complete. The outcome for this is better financial performance and investment decisions.
2. Credit Rating
Further evidence that ESG investments outperform the market is drawn from credit rating companies that monitor performance indices and creditworthiness.
Although ESG investing has been criticized and lambasted for its failure to maximize returns, the available evidence contradicts this assertion.
S&P Global analysis shows that ESG funds outperformed the broader market and their traditional peer funds during the prevailing pandemic.
S&P provides a more in-depth definition of ESG-focused funds. These are funds that focus on a broad screening criterion, including sustainability scores, good corporate governance practices, workplace diversity, exposure to fossil fuels, and commitment to religious principles.
Such developments have broadened the understanding of ESG criteria, especially for more selective investors. S&P Global reports that out of 26 ESG-focused funds, Parnassus Endeavor Fund, controlled by Parnassus Investments, recorded the biggest gains of about 55% growth.
This ESG fund performance, as reported by S&P Global, shows that the more a fund is ESG-focused, the higher its financial performance. ESG investing is increasingly becoming a competitive advantage hence the higher ESG outperformance of the market.
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