This post summarizes and extends a 19 July 2016 talk that I gave at the United States Mission to the United Nations. It was written for CFA Institute and first published by the Enterprising Investor. I'm grateful to Ambassador Sarah Mendelson and the US State Department for the opportunity.
Big questions usually come with incomplete answers.
Are you fulfilling your purpose? Is there life on other planets? Do you drink too much coffee? My own answer to the last one is a definite yes, but it would be hard to answer the other two with even a remotely similar degree of confidence.
Sometime between my parents’ generation and my own, the idea that a business could do both well (in a financial sense) and good (in a social sense) has entered the mainstream. Of course, at a general level, that is a bit like saying how great it is to get equity-like returns with bond-like risk: fluffy, sales-y, and skepticism inducing.
But it’s something people say because there is a large and growing body of evidence that it’s for real.
And if you think like a manager for a moment, it should be intuitive why this is. Start with employee engagement and retention: Doesn’t it stand to reason you’ll be better able to tap into the energy of your employees if they feel their work supports a cause they find meaningful? Isn’t it likely that would have at least some bearing on your ability to compete and, indeed, on whether you succeed?
Yes, But . . .
That intuition is great for managers, but it’s hard for investors to translate into something actionable. We can audit the degree to which a company is “doing good” by examining the information it releases on environmental, social, and governance (ESG) issues, but the path from disclosure to value creation is a murky one.
One straightforward reason for this is that a lot of the information that exists is not intended for investors. And though there is convincing evidence that good performance on selected industry-specific materiality data leads to increased returns, translating those aggregate-level insights into portfolio-appropriate ideas is not a linear process.
With these issues in mind, it seemed natural to ask what readers of CFA Institute Financial NewsBrief thought of how examining these disclosures might yield better returns.
Do you think analyzing ESG factors can boost returns?*
* Results do not add up to 100% due to rounding.
Though only 7% of the 535 respondents said “of course” and suggested we Google it, the responses are quite consistent with my own belief that the investment profession sees at least the seed of alpha generation within ESG disclosures.
This is a question quite distinct from one we’ve asked much more rigorously in the recent past: Do you take ESG issues into account? Of CFA Institute members, 73% say they do, mostly because they view the analysis as a way to manage investment risks or because their clients demand it.
The plurality of respondents (37%) said something quite different: that these factors enter into any complete analysis.
CFA Institute agrees, and that’s why this year everyone who sits the Level I exam will find an added reading on ESG in addition to many others. It’s on the test because it matters: Imagine a company that fits your investment criteria but has a board packed with the CEO’s cousins. Or maybe revenue is growing much faster than costs, but the company releases no information about how it sources its materials.
Why would you ignore that?
I picked extreme examples for the sake of brevity, but they’re not impossible. And it’s hard enough to generate investment ideas, so it makes sense that nearly a quarter of respondents pay attention to this data by default. A further 16% of respondents gave the quite reasonable answer that their level of attention depends, since the information can be low quality or priced in.
This is true of information in general.
Another 15% of poll participants likely think that writing this up was a waste of time, that ESG material consists of nonfinancial information, which for such a cohort qualifies as non-important.
So I’d like to close by sharing some additional evidence that there is a link between strong performance on ESG factors and what investors care about by definition: generating cash from business activity.
- The vast majority of more than 2,200 studies reviewed by Gunnar Friede, Timo Busch, and Alexander Bassen show a positive association between ESG factors and corporate financial performance.
- Of the studies reviewed by Gordon Clark, Andreas Feiner, and Michael Viehs, 88% demonstrated that companies with robust sustainability practices had better operational performance, which translates into cash flow.
- An excellent 2012 study by Mark Fulton, Bruce M. Kahn, and Camilla Sharples states “We were surprised by the clarity of the results we uncovered.” All of the 100-plus studies they reviewed found that companies with high ratings for corporate social responsibility have a lower cost of capital.
Those studies say other things too, and are well worth a read. But those excerpts should give a good sense that there is at least the outline of an alpha opportunity to be had by looking at ESG data.
But translating that opportunity into performance is difficult. Just take it from someone who’s done it: David Blood, a founder of Generation Investment Management, notes that he is reluctant to talk about performance “In some respects because [he is] suspicious.” And it’s appropriate for you to hold that same suspicion.
It might be worth examining your suspicion more closely if this passage from a 2015 Morgan Stanley report on sustainable investing has no effect on it (emphasis theirs).
“We reviewed a range of studies on sustainable investment performance and examined performance data for 10,228 open-end mutual funds and 2,874 Separately Managed Accounts (SMAs) based in the United States and denominated in US dollars. In the scope of our review, we ultimately found that investing in sustainability has usually met, and often exceeded, the performance of comparable traditional investments. This is on both an absolute and a risk-adjusted basis, across asset classes and over time.“
That’s not the end of the discussion, but it does move it along. To me, it means that there is room to consider a sustainable approach to investing alongside value investing or statistical arbitrage as a tool that a professional investor can use to generate alpha.
Whether you go out and do it is up to you. If you’d like to, CFA Institute has plenty of information to help.