Friday, 1 August 2014

Socially Responsible (Environmental, Social, Governance) Investing - What difference does it make?

Back in 2009 we first wrote about Socially Responsible Investing (SRI), also commonly known as investing based on Environmental, Social and Governance factors (ESG).  The chart below from one of the ESG ratings providers, Thomson Reuters, shows what the process considers.
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The question of whether an investor can expect to get better, or worse, results than simply buying an index fund that owns a piece of every public company regardless of SRI/ESG factors matters. SRI/ESG is a topic of continuing interest to us, with enough past posts to merit its own category in our guide to online investing. Let's see what recent research has found and examine the latest return results of the actual available funds.

SRI screening makes a small but significant contribution to the variability of performance
In the January 2014 paper Do Social Responsibility Screens Really Matter? A Comparison with Conventional Sources of Performance authors Marie Brière, Jonathan Peillex and Loredana Ureche decompose the sources of performance variability of SRI equity funds worldwide between 2006 and 2012. Unsurprisingly, overall market movements determined the bulk - 70% - of return variability. Most of the remaining 30% was down to asset allocation and active management (stock picking) about in equal measures in a range of 10-14% for each source. But SRI screening itself, either screening in stocks with good ESG ratings or screening out "bad" tobacco, alcohol, weapons or nuclear stocks, accounted for 6% of the return variability. As the authors conclude, "SR screens matter but, like active portfolio choices, they have a limited impact on total equity fund performance, heavily dominated by market movements".

High ESG scoring companies have better risk-adjusted returns
Indrani De and Michelle Clayman tell us in The Benefits of Socially Responsible Investing: An Active Manager's Perspective that high ESG scoring stocks tend to exhibit lower volatility, giving them a more favourable return to volatility (standard deviation of price movements) ratio i.e. risk-adjusted return. Better yet, this lower volatility was more accentuated when markets were most volatile in their study period of 2007 to 2012, which covered the horrors of the financial crisis. Protection in the worst times sounds pretty good. The catch is that the difference in volatility is not that huge as we can see in the chart from their study below. The stocks in the bottom 10% of ESG scores, the red bars, had a lower standard deviation of returns, in 2008-2009 at the worst of the financial crisis, compared to the top 90% ESG scoring companies in the blue bars. Di and Clayman conclude that ESG ratings are more useful as risk indicators than as predictors of return out-performance - " while ESG ratings may not have predictive alpha capability, they do predict the stock risk".
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Material vs non-Material factors
The research on ESG was refined in a March 2015 working paper by Harvard Business School professors Mozaffar Khan, George Serafeim, and Aaron Yoon. Corporate Sustainability: First Evidence on Materiality found that it was important to distinguish ESG factors that are material, i.e. that make a difference to financial and stock market performance, from those that do not. Each sector and industry has different material factors. No single factor is material across the board. The enticing results are depicted in this chart from the study. Companies that do something about highly material factors and ignore insignificant factors perform the best - see the box at the upper left.
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The Sustainability Accounting Standards Board in the USA has published a detailed Materiality Map of what matters for which sector and industry amongst five ESG main factor groupings (Environment, Social Capital, Human Capital, Business Model and Innovation, Leadership and Governance) subdivided into 30 specific factors with measurable performance metrics. The Map shows, for instance, that fair marketing and advertizing is material for asset managers while employee health safety and well-being are non-material but for a railway company the opposite holds.

Stock returns for SRI/ESG investing strategies seem to track the market quite closely
The total returns performance of ESG-selected stocks does not seem to differ much from that of mainstream capitalization weighted indices, as the following recent chart from Thomson Reuters shows. The lines of the cap-weight vs the ESG index are hardly distinguishable.
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In the case of Canada the one and only SRI/ESG oriented ETF, the iShares Jantzi Social Index ETF (TSX symbol: XEN), delivered a five-year total return (price appreciation plus distributions) of 10.32%, slightly ahead of the large cap iShares S&P / TSX 60 Index ETF (XIU) at 9.44%, which it is most comparable to, and slightly behind the broad market iShares Capped Composite Index ETF (XIC) at 10.71%. The latest returns table from index provider Jantzi going back to 2000, which notable excludes the return-reducing effect of XEN's 0.4 to 0.5% higher MER fee over those of XIU and XIC, suggest the same -  in Canada it is also a close race.

It may well be that the market has recognized the superior accounting performance of high ESG companies and factored that into their market price, much reducing or eliminating the possible stock return advantage. De and Clayman cite research suggesting so. A 2013 news item that one in five institutional investors in the USA consider ESG factors can be seen as a glass half-empty or half-full argument, but 20% is enough to have influence on market prices. Certainly company CEOs are paying attention, as major consulting outfit McKinsey's July 2014 Global Survey attests. De and Clayman relate that "the share of S&P 500 companies filing sustainability reports has increased from 20% in 2011 to 72% in 2013".

Investor fund choices still mainly mutual funds and a handful of ETFs
Maybe it's the close alignment of returns with mainstream cap-weight funds or that, if one takes the trouble to look inside, the holdings of the  SRI/ESG funds have a high degree of overlap with cap-weight funds. But the reality is that ordinary retail investors have not flocked to buy such funds. As we noted above, there is still only the one ETF in Canada devoted to an SRI/ESG strategy - XEN - and it has attracted puny assets of $25 million since 2007 inception. Canadian mutual funds have been more successful in attracting investors but the size of assets is still not impressive. The latest June 2014 quarterly table from the Responsible Investment Association lists 26 Canadian equity mutual funds with $1.8 billion in total assets, not much considering there are fifteen individual ordinary Canadian equity funds with the same or more in assets according to GlobeInvestor.

Canadian investors can also buy a handful of SRI/ESG ETFs on US markets. The two serious contenders are well established:
- iShares MSCI KLD 400 Social ETF (NYSE: DSI) - 2006 inception, $372 million USD in assets, tracking 400 US companies, MER 0.5%, 5-year return 17.9%
- iShares MSCI USA ESG Select ETF (NYSE: KLD) - 2005 inception, $267 million USD assets, 100 stocks only and excludes tobacco companies), MER 0.5%, 5-year return 17.36%
In the USA, five-year returns of the cap-weight benchmark have been better than the above ESG funds. The iShares Core S&P 500 ETF (NYSE: IVV) compound annualized return of 18.74% outstrips that of both KLD and DSI.

Finding individual companies that meet the SRI/ESG criteria:
1) Holdings listings of ETFs or mutual funds on the provider websites
2) Constituent listings of various indexes -
... Thomson Reuters' Developed Markets ex-US, which includes Canada, or Large Cap US
... S&P/TSX index on TMX Money, the 60 ESG
... Sustainalytics' Global Compact 100 and STOXX Global ESG Leaders, which include Canadian and US companies
... Calvert Social Index of large and mid-cap US companies

Bottom line: Investing by SRI/ESG principles may make you a bit better off financially, or maybe not, but it probably won't make you much worse off either.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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