Why responsible investing can drive long-term returns

In emerging markets, the outperformance is even more evident

However, it’s important to note that the parent index is broad and not all markets behave the same. If we carve out emerging markets, we observe a particularly stark difference in returns between the traditional index and its ESG derivative. Over the observed period, the following chart shows that the MSCI Emerging Markets ESG Leaders Net Return index significantly outperformed its parent MSCI Emerging Markets Net Return index, delivering 6.52% versus 2.87%, and with lower volatility (the standard deviation for the MSCI Emerging Markets ESG Leaders index was 35.8% versus 37.5% for the parent index, based in US dollars). However, the case isn’t the same for developed markets — the MSCI World Net Return index and its respective ESG Leaders index both deliver 6.30% over the period. Positively, this tells us that screening for ESG hasn’t had a negative impact on developed market returns since late 2007 to date. 

Why do ESG leaders outperform traditional equity indices?

ESG factors act as a risk mitigation tool, favouring quality businesses with preferred practices across the three pillars (environment, social, governance), and steering away from those with poorer practices and potential regulatory infractions. Given higher-quality companies tend to lag in ‘risk-on’ markets and perform better when equity markets are weak, we expect ESG-screened indices to do the same. Furthermore, these higher-quality businesses are less likely to be involved in environmental disasters, corporate governance issues, human rights and labour rights violations, as well as other controversies, which could incur significant cost to those businesses and ultimately affect share prices negatively. We have observed established companies such as Volkswagen and Pacific Gas & Electric suffer at the hands of such controversies. Therefore, more ESG-compliant companies should typically be less susceptible to surprises (financial or reputational) and in a better position to consistently deliver over the long term.

Why do performance differentials vary across markets?

The impact of an ESG overlay on the MSCI Emerging Markets Net Return index compared to the more encompassing MSCI All Country World Net Return index is an interesting one. In many cases, emerging markets may not have the same regulatory and governance infrastructure in place as some developed markets, which means infractions and governance issues may arise more often. These are naturally more inclined to incur costs to the business, and cause stock market volatility and potential underperformance. By down-weighting or excluding those companies, the MSCI Emerging Markets ESG Leaders index should look notably different to its parent index and, therefore, should be materially less affected by negative surprises.

It's worth noting that ESG indices tend to have a stronger bias towards large-cap companies than traditional indices. This is because larger businesses tend to have more resources to dedicate to environmental, social, and governance issues, as well as disclosure, which ESG ratings are based on. As such, they typically score better than smaller firms. Such nuances may also exist across sectors, but that is beyond the scope of this paper.

Fixed income — mitigating risk and preserving returns

For fixed income, while the return differential is smaller, it shows that returns don’t have to be sacrificed and risk can be mitigated by focusing on sustainable bonds. To compare the difference in performance between traditional bonds and sustainable bonds, we analysed the Bloomberg Barclays Global Aggregate index as a proxy for traditional bonds and the Bloomberg Barclays MSCI Global Aggregate Sustainable index as a proxy for ESG bond investing. The latter positively screens for issuers that better manage ESG risks relative to an industry peer group based on Bloomberg Barclays indices.

The following chart shows that between January 2008 and May 2019 both indices delivered similar returns (the Sustainable index delivered 4.98% while the Global Aggregate index delivered 5.04%). Volatility was also similar, with the Sustainable index generating a standard deviation of 5.56% versus 5.58% for the Global Aggregate index. Pleasingly, the Sustainable index outperformed during ‘risk-off’ periods such as in 2008 and 2011. 

Why the lack of return differential?

The relationship between ESG and a bond’s performance is less clear than with equities. Taking credit as an example, higher-quality companies (indicated by higher ESG scores) are likely to have lower credit spreads and should, in theory, generate lower returns.