ESG Uncovered: Can Sustainability Drive Investment Returns?

Freddy Lim

Co-founder and CIO

22 February 2021

What ESG is, in a nutshell

ESG stands for Environmental, Social and Governance, and refers to the sustainability and societal impact of an investment. Below are some examples of some of the key issues covered by ESG.

ESG investing has been getting more popular in recent years, but its standards and definitions are still emerging and are likely to be re-written over time. Nonetheless, ESG scores indicate how sustainable an investment is, allowing investors to allocate their funds toward businesses that contribute positively to the environment and to society.

From an ethical standpoint, measuring non-financial factors, such as sustainability, is important, but that doesn’t mean that investors have to sacrifice returns in order to invest ethically.

We examined how ESG affects returns, and learned that ESG is a factor that offers investors returns and diversification. We’ll find out more below, by taking a data-driven approach to see what ESG investing means for your portfolio. 

ESG contributes strongly to returns

Traditional investment theory believes that a portfolio’s returns come from market growth and risk-free assets, such as, short-dated government debts or fixed deposits. In hindsight, we can see that a shortcoming in this theory is that it ignores other sources of returns.

But, as it turns out, there are other factors* that contribute to an asset’s return. These factors include the value of an asset, its size, momentum, growth, quality, volatility, and dividend yield, among others. Another factor that drives returns is an asset’s ESG score.

One of the early perceptions of ESG was that, although it exposed investors to important values, it came at the cost of returns. In other words, many speculators thought values and returns weren’t necessarily compatible. They were wrong: actually, sustainable investing generates strong returns.

Here’s how the ESG factor performs against other factors relative to the MSCI World Equities Index. For our analysis, the ESG factor is proxied by the MSCI ESG KLD 400 Index**.

Note: Growth is proxied by StashAway's proprietary growth index. It’s an index derived from the yearly rate of change in industrial production across Brazil, China, Denmark, the eurozone, India, Japan, Mexico, Norway, Poland, Russia, Singapore, South Korea, South Africa, Sweden, Taiwan, Turkey, United Kingdom and the US.

Overall, we can see that ESG is a strong factor in returns:

  • ESG is the second best factor of investing, after quality (this measures the returns of stocks that have low debt, stable earnings growth and low leverage).
  • In months with positive growth, the ESG factor leads at 2.7%.
  • ESG, along with momentum and quality, consistently performed across months of positive and negative returns. This is compared to value and dividends, which consistently underperformed.

StashAway and ESG 

The StashAway investment team is excited to share this analysis. It means that investing in ESG is not just trendy, but also adds value to our clients’ portfolios. We now know that the ESG factor drives returns in our existing portfolios, while contributing positively to sustainability - an added benefit to investors to whom this is ethically important.

At StashAway, our current portfolios score well on ESG metrics, ranging from 3.21 to 3.57 out of 5.

Our findings present an opportunity to introduce 2 new ESG ETFs into our investable universe:

  • iShares ESG Aware MSCI USA ETF
  • iShares ESG Aware MSCI Emerging Markets ETF

This means that StashAway’s investment algorithm will now be able to choose from a pool of ETFs that also includes the 2 ESG ETFs above. So, you might not see the ESG ETFs in your portfolio straight away, but they may be included in your next portfolio re-optimisation. These ETFs will complement our existing portfolios, enhancing our sustainability scores while maintaining a strong focus on risk-adjusted returns.

*The factor definitions are outlined in Exhibit 1 of  “Foundations of Factor Investing, MSCI Research Insight, Dec 2013”. “Value” measures the excess returns of stocks that have low prices relative to their fundamental value. “Size” measures the excess returns of smaller firms (by market capitalization) relative to their larger counterparts. “Momentum” measures the excess returns of stocks with stronger past performance”. “Quality” measures the excess returns of stocks that are characterized by low debt, stable earnings growth and low leverage. “Min Volatility” measures the excess returns of stocks selected under the minimum variance strategy. “Dividends” measures the excess returns of stocks that have higher than average dividend yields.

**The MSCI KLD 400 Social Index is a capitalisation weighted index of 400 US securities that provides exposure to companies with outstanding Environmental, Social and Governance (ESG) ratings and excludes companies whose products have negative social or environmental impacts (e.g. alcohol, tobacco, firearms, gambling, nuclear power or military weapons). The parent index is MSCI USA IMI, an equity index of large, mid and small cap companies.