This article is a part of NordSIP Insights – Handbook – “Systematically Sustainable”.
By integrating ESG factors into their portfolios, investors are increasingly recognizing they can go beyond conventional financial criteria and invest in companies whose emphasis on corporate citizenship matches their own values. Yet even the staunchest proponent of sustainable investing acknowledges the importance of financial criteria. How, specifically, can we combine traditional and ESG research to achieve investment objectives surrounding risk, return and ESG performance?
by Michael Hunstad, PhD, Jordan Dekhayser, CFA and Emily Lawrence, Northern Trust
The Financials Matter for ESG
Over the past several years, we have all witnessed high-profile issues that have provided investors with hard-knocks lessons about how poor management of ESG risks can destroy both value and reputation. ESG data is certainly helpful to understanding these headline grabbing risks, but picking winners and losers using only this data does not illuminate all the risks and potential opportunities.
So while ESG information is invaluable in identifying risks not apparent in financial statements, we should not ignore company financials. Financially high-quality companies have consistently outperformed their low-quality counterparts in developed and emerging markets. Compared to their peers, high-quality companies are more profitable, have more conservative balance sheets and generate greater cash flow. Yet, taken alone, quality tells us nothing about a company’s ESG strategy.
Quality and ESG, taken together, can best be understood as two dimensions of the same underlying theme: sustainability. In the context of ESG investing, there are financial and non-financial sources of sustainability. In order to be financially sustainable, a company must demonstrate characteristics such as strong return on equity, consistent cash flow and prudent deployment of capital. From a non-financial perspective, a company must have strong credentials in managing their exposure to ESG-focused risks and opportunities. Exhibit 1 elaborates on this view of sustainability.
The Intuitive Relationship
Companies need to plan for the long-term with concrete action today. Although global warming is arguably a longer-dated risk, companies reliant on fossil fuels need to plan for scenarios on the near-term to respond to climate risk, transition risk and regulatory risk.
Corporate governance is another example of how ESG issues can affect performance — both near- and long-term. Having the proper board structure, including the independence of key committees, strong shareholder protections and executive pay aligned with performance are all desirable governance features increasingly demanded by investors. However, a well-structured board and a strong plan around environmental risks and opportunities is not sufficient to maintain sustainability. Companies must be profitable to sustainably act on ESG considerations.
Indeed, one may deduce that a company adept at managing its ESG risks is likely to adroitly manage other aspects of the company as well, giving it a greater chance of being of high financial quality. This intuitive relationship between quality and ESG is what makes this combination of factors so powerful!
Does the strong conceptual pairing of quality and ESG hold up empirically? Our research suggests that it does. In Exhibit 2, we show the performance of the Russell 1000 Index universe and the MSCI World Index universe broken into four groups based on quality and ESG ratings. Note that, in each case, the combination of high quality and high ESG is the top performing combination of the two. Although the time horizon of our analysis is relatively short, we can still hypothesize as to why this return pattern is occurring. One explanation suggests this pairing identifies companies engaging in longer-term strategic planning around ESG risks and opportunities while maintaining strong balance sheets and delivering bottom-line results.
Making It Work for Investors
While combining quality and sustainable investing concepts into one portfolio is simple in concept, as always execution requires a good amount of skill. In our related strategy, we combine our proprietary definition of quality and integrate ESG criteria. We use ESG ratings to identify the companies that manage material ESG risks better than others, and we exclude firms involved in recent egregious controversies related to ESG or with more than 5% of revenue from tobacco products or civilian firearms. We also reduce the carbon footprint (carbon emissions and reserves) by 50% from the benchmark.
So no, investors don’t have to sacrifice performance to invest sustainably. In fact, combining high financial performers that also value sustainable business practices makes as much business sense as it makes good sense.
Directed to eligible counterparties and professional clients only and should not be relied upon by retail investors. The information is provided for informational purposes only and is not intended to be, and should not be construed as, an offer, solicitation or recommendation with respect to any transaction and should not be treated as legal advice, investment advice, or tax advice. Northern Trust and its affiliates may have positions in and may effect transactions in the markets, contracts and related investments different than described in this information. This information is obtained from sources believed to be reliable, and its accuracy and completeness are not guaranteed. Simulated past performance and actual past performance is no guarantee of future results. Investing involves risk- no investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Northern Trust Asset Management is composed of Northern Trust Investments, Inc., Northern Trust Global Investments Limited, Northern Trust Fund Managers (Ireland) Limited, Northern Trust Global Investments Japan, K.K., NT Global Advisors Inc., 50 South Capital Advisors, LLC and investment personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.