ESG is more than ‘good karma’ and analysis can help pick a winner

ESG investing has grown in popularity in the past five years. Investment based on environmental, social and governance criteria accounts for $12tn in assets under management in the US, according to the Forum for Sustainable and Responsible Investment, while the Global Sustainable Investment Alliance shows a worldwide figure of nearly $23tn. Both numbers make up about a quarter of the respective market totals.

Much of this popularity comes from the generally misguided faith that the good karma of investing in ethical (or high ESG) companies should lead to a better outcome.

Despite the desire and discourse — European pension funds and Japan’s Government Pension Investment Fund in particular have been supportive of ESG — one impediment has been a perception that investment results sometimes suffer.

Academic research on ESG investing is mixed: studies that say ESG funds do not outperform are roughly matched in number by those that show outperformance.

The latest research is more positive. Analyses of Bloomberg and Thomson Financial databases show that opportunities for better returns from ESG can be effectively identified by focusing on the cost of capital.

Specifically, this research shows that investing in ESG firms “in need” — those receiving little publicity or love from the capital market — can maximise the social value of ESG investment by supplying capital to the groups that need it most while delivering better returns over time.

Consider the solar sector. It was once an example of “ESG in need” yet has moved to being far from that, given over-investment. Its global new investment ranked third in 2006, behind wind and biofuels but within just five years it eclipsed the other green energy sectors combined.

In that period, the sector’s stock market value began to shrink, with solar indices that saw an early boom dipping sharply; some dropped to values as low as 95 per cent below their 2007 peak.

Excessive investment in a popular ESG theme can have an impact, be it on that theme or sector itself. Too much investment in solar led to an overproduction of solar panels, affecting the value of that space. It also prevented each dollar spent from doing as much good as it could have done in less-loved ESG projects.

If we accept the premise that investing in lesser known ESG themes and companies can lead to better returns, the million-dollar question is how to identify the groups likely to provide the best investments.

How do we distinguish the ESG companies “in need” from those in financial distress? Both groups lack ample access to capital but the latter are more likely to be bad value or are operationally incompetent. Our analysis suggests that lines can be drawn in company characteristics such as quality of cash flow, leverage and productivity.

A more refined approach to ESG is needed if investors wish to express their values in a way that shows both good karma and good profitability.

Put simply, focusing specifically on those companies with a high cost of capital (but otherwise not distressed) rather than on a broad ESG basis will allow investors to meet all their aims.

This “ESG in need” concept also raises the question of where investors should look, particularly in terms of geography. The developed markets in Europe and the US have woven ESG into their asset allocations to a varying extent. In contrast, the concept has yet to make significant inroads in Asia’s emerging markets.

Fast progress in sustainability and governance among Asian companies may help ESG investing in the region. In addition to Japan’s GPIF, leading institutions such as Taiwan’s Bureau of Labor Funds and the Korea Investment Corporation are devoting greater resources to sustainable investment strategies and governance, bolstering support to more ESG mandates.

In terms of corporate responsibility reporting rates, large Asian companies that once lagged behind European counterparts now achieve parity, in no small part due to higher regulatory requirements.

Should this continue and other smaller companies follow suit, it could have a significant effect on the emerging Asia market. That would benefit investors, making ESG as much about good karma as about sound investing.

Jason Hsu is chairman and CIO of Rayliant Global Advisors