Sustainable investing: can you do well by doing good?

Ethical investors can outperform if they engage with corporate sinners

Ireland’s sovereign wealth fund is set to divest from fossil fuel stocks, the Church of Ireland has pledged to do likewise by 2022, while Norway’s $1 trillion sovereign wealth fund, the world’s largest, doesn’t invest in tobacco shares and has proposed steering clear of oil and gas stocks.

Sustainable investment is becoming increasingly mainstream, but can you really “do well by doing good”, to borrow that oft-used phrase? Or does embracing ethical investment principles mean sacrificing returns?

Far from involving a financial hit, sustainable investment can be “a route to superior portfolio returns”, says Swiss fund giant Pictet Asset Management. The enormous growth in the industry suggests investors are buying into that message – more than a quarter of the $88 trillion assets under management globally is now invested in environmental, social and governance (ESG) assets, McKinsey estimated last year.

Some of that money, as in the case of the Irish and Norwegian sovereign wealth funds, is invested in funds that exclude so-called sin stocks that make money from alcohol, tobacco, fossil fuels and so on. However, a policy of engagement, whereby shareholders seek to use their influence to improve companies’ ESG policies, is much more common these days.


As a result, some surprising names crop up in ESG funds and indices. British American Tobacco and Royal Dutch Shell, for example, are among the top holdings in Vanguard's "socially responsible" European Stock Fund, while mining giants BHP Billiton and Anglo American can be found in the FTSE4Good UK index.

While different ESG investors may diverge in their approach, most agree there are obvious financial benefits to adopting some kind of socially responsible criteria, and that ethical companies often tend to be better investments.

Earlier this year, billionaire investor and Blackrock founder Larry Fink argued such companies would be rewarded by "increasingly aware customers", allowing them to protect their brand, attract top talent, and "better navigate the transition to an increasingly low-carbon and digital economy".

Climate change pain

In June, fellow billionaire Jeremy Grantham went further. A keen environmentalist, Grantham referred to how Bank of England governor Mark Carney "keeps telling the investment community" that it is "severely underestimating the pain of climate change in various quarters, notably in the oil industry, and, to a lesser extent, the chemical industry".

Oil may enjoy a “last hurrah before the electric cars arrive”, said Grantham, “but when they do, there will be some tough times for a long time”. Long-term investors in such industries will, he warned, be left with stranded assets.

In contrast, subsidies in areas such as solar storage and wind power mean they are “becoming economic far faster than anyone realised”. Collectively, green investments will enjoy more rapid growth, said Grantham. “You can virtually depend on that.”

Whatever about future developments, there is already strong evidence that sustainability and financial performance go hand in hand, says Pictet Asset Management. “Companies that actively apply sustainability principles tend to have higher credit ratings, lower cost of capital, stronger finances and better share price performance,” it says.

American companies that have scored highly in climate change management “have delivered higher returns on equity, reduced earnings volatility and shown stronger dividend growth compared to low-scoring peers”. Firms with poor ESG practices, on the other hand, “can suffer reputational and financial damage”, as was the case with BP following the 2010 Deepwater Horizon oil spill and Volkswagen in the aftermath of its emissions test cheating scandal.

More recently, it notes, London regulators refused to renew Uber’s operating licence, saying the company’s conduct demonstrated a “lack of corporate responsibility”.

Sin stocks

However, sceptics can point to evidence showing sin stocks have traditionally outperformed conventional investments. Tobacco, for instance, has historically proven to be the best-performing stock market sector. Some research suggests that shunning of tobacco stocks results in them becoming cheaper than they should be, less conscientious investors accordingly profit by nabbing these bargain stocks sporting high dividend yields.

That interpretation is rejected by ESG provider Robeco. In a study published last year in the Journal of Portfolio Management, Robeco's David Blitz argued sin stocks' outperformance is not linked to them being systematically underpriced due to reputational risk; rather, it's because they tend to be highly-profitable, high-margin companies. Ethical investors looking to replicate sin stock outperformance, the study said, could do so by screening for similarly profitable stocks.

Still, any strategy that restricts one’s investment universe must, say sceptics, inevitably limit returns. A bad company is not necessarily a bad stock; if the stock price falls to sufficiently cheap levels, it will likely prove to be a profitable investment.

What does the research say? A 2015 meta-analysis co-authored by Deutsche Asset Management analysed 2,200 studies on the subject and concluded “the business case for ESG investing is empirically very well-founded”, with 90 per cent of the studies saying ESG investing did not negatively impact financial performance. That’s echoed by Pictet, whose review of the evidence suggests ESG investing “carries no performance penalty and has the potential to boost returns”.

Against that, there is the aforementioned outperformance of sin stocks. Not only that, the idea that ESG investing represents a free lunch was contradicted in March by Norway’s sovereign wealth fund. It found that since 2006, its decision to exclude certain stocks had cost the fund in some instances while boosting it in others. Overall, cumulative returns over the entire period were lower by a relatively modest 1.6 percentage points – a price the fund apparently deems worth paying, given it is considering extending its list of banned stocks.

Restrictive approach

Divesting from just one sector is unlikely to substantially hurt returns, according to Jeremy Grantham. His fund, GMO, examined what happened when one sector was removed from an S&P portfolio. The answer: not much. "You can divest from oil – or about anything else? – without much consequence for performance," concluded Grantham. However, common sense suggests the more restrictive one's approach, the greater the risk of underperformance. According to to London-based Sarasin and Partners, if a fund excluded companies with revenues related to alcohol, gambling, tobacco, adult entertainment, weapons, shale oil and tar sands producers, it would be excluding 22 per cent of the entire investment universe.

In contrast, ESG investors who prefer engagement to divestment are likely to enjoy financial rewards, according to a 2015 study authored by renowned London Business School finance professor Elroy Dimson. Typically, a company’s financial performance improves and its stock price gains if institutional investors persuade management to improve ESG practices, the study found. Outperformance is especially marked if the company improves policies relating to corporate governance and climate change. Engaged investors have nothing to lose, as there is no market reaction to unsuccessful engagements.

In other words, ESG investors can outperform if they engage with corporate sinners. In contrast, investors who veto such companies, who wait until they have cleaned up their act, will, as Dimson put it, “be too late to the party”.