Socially responsible investing, also referred to as ethical, sustainable or ‘green’ investing, seeks a philosophy to establish both financial return and social or environmental good.
Socially responsible investing is plagued with the question of whether portfolios based on ESG (environmental, social and governance) criteria financially underperform. Economists have been testing this hypothesis for decades, however, and have now largely refuted this assertion. First came studies on the performance and value of companies rated on ESG factors, and then meta-studies on those studies, aggregating data from different companies, countries and time periods. Deutsche Bank and partners executed a study that assessed 2,200 other studies. They found that while 10% of the existing research showed evidence of pro-ESG companies underperforming, 90% of the evidence showed performance either just as good or better. When you look at the research on why, it makes a lot of sense.
A report by the Australian Centre of Financial Studies at Monash Business School, presents a theory, that suggests that socially responsible companies outperform other companies over the long run by building employee and customer loyalty; avoiding reputational loss and using resources more sustainably.
Arabesque, a London-based socially responsible investment company, teamed up with researchers at Oxford University to work on another meta-study, this time to better understand why ESG companies might outperform.
Environmental. Good environmental practices may actually translate into a competitive advantage – for example, if you’re not paying for emissions credits, your operational costs are lower. The research showed that pollution reduction, proper waste management procedures, and implementing global standards for environmental policy can all have a positive impact on company performance. More tellingly, they found that carbon emissions, other forms of pollution, and bad environmental policies often have negative correlations with performance – even more so if the company doesn’t disclose them.
Social. Social factors encompass a company’s relationships with three major stakeholders: its employees, its customers and its community. If those relationships are strong and positive, it can positively affect the bottom line. Specific examples of good social practices include a diverse workforce, product safety and community reinvestment. Employee satisfaction – a proxy for recruitment, retention and motivation of good workers – can be a strong indicator of performance or stock price. It’s unsurprising that a diverse, satisfied, safe and comfortable workforce would do good work.
Governance. A small and transparent board structure, reasonable executive pay, and a good incentive system are all good governance practices. The research indicates that these practices and others can be linked to a number of payoffs, including reduced borrowing costs, high company valuations and strong operational performance. One study found that when it was revealed that companies had misrepresented their financials, their stock prices suffered, arguably showing that consumers – and the market – seek honesty and transparency in corporate behaviour.
Nonetheless, it would be unfair to say that socially responsible investing doesn’t carry any of its own limitations. Socially responsible funds due to the application of negative screens, may less diversification within portfolios as there are limitations on which companies or industries that can be invested in.
Of course you should do the right thing for its own sake. But isn’t it nice to know we live in a world where – according to most of the research – investing for social and environmental good can be rewarded in the market? Of course, historical performance does not necessarily guarantee future results, and every investment and portfolio contains risks. We encourage you to consult this and other research yourself and draw your own conclusions. We hope we have been able to dispel some notions about responsible investing, in terms of what it is about, and how ESG practices can be beneficial and even profitable to a company, and we look forward to your interest in investing with ethics, the environment and social good in mind soon.
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