Investors should beware that ESG strategies can miss out on significant short-term gains if they avoid areas rated negatively on this criteria, according to Karen Ward, chief market strategist for EMEA at JP Morgan Asset Management.
However, she added that over the longer term, the evidence suggests that an ESG focus should help improve performance.
An article published by Trustnet this morning showed that just one of the top-quartile ESG funds in 2020 has maintained this relative performance so far in 2021, which has been attributed to the switch from growth into value.
Ward said this is not surprising.
“At certain points in the economic cycle, excluding certain companies – such as gambling, tobacco, nuclear power, weapons, alcohol and energy companies – for ESG reasons can have meaningful implications for relative performance,” Ward said.
“Most obviously, excluding traditional energy companies from a portfolio will likely lead to outperformance when oil prices are falling, but potentially underperformance when oil prices and energy prices are rising.”
Performance of ex-energy indices since 2020
Source: J.P Morgan Asset Management
She outlined that if energy is a large proportion of a benchmark, the relative impact is even greater. For example, energy is more than 10 per cent of the MSCI UK index, but just 3 per cent of the US market.
“Companies that do not have good long-term growth opportunities or ESG scores can still generate good financial returns when profits are returned to shareholders or when there’s a grab for yield,” she added.
“Of course, for many investors, any return sacrifice may be entirely acceptable given their broader investment ambitions beyond financial returns.”
Ward and the team at JP Morgan use empirical back-testing to assess relative performance, but conceded that this can sometimes be redundant given how quickly ESG investment is changing.
In particular, she noted there are issues with gauging ratings against the three distinct E, S and G (environmental, social and governance) categories.
“Methodology can be opaque and subjective and different providers often produce conflicting scores,” said Ward.
“A well-known electric vehicle producer is an oft-cited example: it is rated highly by one rating agency for its green credentials and poorly by another based on the agency’s assessment of its governance.”
Secondly, coverage of companies isn’t always complete, which is especially prevalent in smaller companies, fixed income markets and emerging markets, where language issues can be a barrier to collating full and accurate data.
Thirdly, Ward added that the further back you go, the more likely it is that the scoring data does not capture the real-time ESG challenges.
“The data may not have been available or disclosed at the time, and, more importantly, the relevant data to asset pricing has likely changed over time.
“Governance may have been the biggest non-financial metric of concern for assessing the sustainability of corporate performance 20 years ago, whereas today, environmental issues are increasingly moving into sharper focus, as is the diversity of the workforce.”
Another important question is whether it is the absolute ESG score or the change in the score that matters.
“It may be that the answer is both, with ‘good’ companies benefiting from macro news such as regulation and policy announcements and improvers representing company-specific or micro developments,” Ward continued.
However, she noted the figure below, which uses JP Morgan’s proprietary ESG scores, suggests there is a clear relationship between a focus on this theme and performance relative to the benchmark.
Mean active return by ESG quintile/ Return on equity by ESG quintile
Source: J.P Morgan Asset Management
There is also a relationship between ESG scores and other traditional financial characteristics of “good management”, such as high return on equity, low leverage and low earnings variability.
“For this reason, incorporating ESG factors is often seen as an additional quality screen and the performance of companies screened on quality metrics is clear over the long term.”
Performance of indices over 10yrs
Source: FE Analytics
Over 10 years, the MSCI AC Europe Quality index has returned 50.96 per cent, compared with 23.09 per cent from the MSCI AC Europe index.