Socially responsible investments cement longer term outperformance

It’s often assumed that socially responsible investing means sacrificing performance, but it may actually improve long term returns.

| 6 min read

Many investors have often assumed that socially responsible investing (SRI) means sacrificing performance compared to a ‘hard-nosed’ approach where no ethical exclusions are made and there is no explicit reference to environmental, social or governance (ESG) factors. The argument goes that any reduction in the number of possible investments available either reduces return potential or increases risk.

That sounds logical, and undoubtedly the more an investment universe is narrowed down the more likely it is investment returns deviate from the broader market return, especially in the short term. However, there is mounting evidence that the suspected underperformance of this form of investing isn’t borne out in reality. Furthermore, recent market action appears to underscore the case for backing companies with strong ESG credentials.

Crunching the numbers

Many fund managers integrate some form of ESG research into their processes, even though it may not always be identified as a separate strand. However, someplace more emphasis on it than others. In the case of funds labelled ‘ethical’ or ‘sustainable’, it should be central to the stock selection methodology, and we can compare the returns from these funds to their respective industry averages.

Using data from FE Analytics we looked at the average performance of funds marketed as ethical, socially responsible and sustainable in the Investment Association UK All Companies and Global sectors versus their benchmarks over 1, 3, 5 and 10 years. We chose these sectors because they contain the largest number of funds of this type. We then compared this to the average performance of all the other funds in the sector.

We also looked at performance in 2020 to date to see how the funds fared in what has been one of the most volatile periods that stock markets have experienced in living memory.

Table: Performance (% total return) of UK All Companies and Global SRI and non-SRI fund averages versus the benchmark index

Performance (% total return) of UK All Companies and Global SRI and non-SRI fund averages versus the benchmark index
Source: FE Analytics, data to 03/09/20; past performance is not a reliable indication of future returns.

Who cares wins?

Socially responsible investing has clearly helped returns in the shorter term with both UK and global SRI funds providing better results on average in the year to date and over one year. That’s not surprising given some of the areas that are normally largely excluded from these funds. For instance, energy has been among the worst affected areas in the recent sell-off as demand has fallen.

In addition, many SRI funds have a slight bias towards stocks and sectors that are higher priced but have more certain earnings, or faster growth potential. ‘Quality growth’ stocks have continued to be in the ascendency against cheaper ‘value’ areas, while investors have perceived that many companies in the fields of healthcare and technology could emerge from the crisis relatively unscathed.

The longer-term experience is positive too, though. In the UK All Companies sector, the results clearly show that investors have been significantly more likely to generate outperformance over the past 3, 5 and 10 years from ethical or sustainable funds than from standard funds.

The picture is less clear in the global sector with a slightly worse outcome over ten years. Given that other factors may be at play here – notably that global SRI funds tend to be overweight Europe and underweight US, an impediment over most of the time periods in question – it seems like a highly creditable result. The global index has also been a hard one to beat for all funds not harnessing the significant outperformance of the largest tech companies.

Is ESG a winning formula?

As well as factors surrounding style and sector positioning, there is perhaps a broader reason for the generally superior returns. Any diligent investor should undertake to understand and quantify ESG factors to properly assess risk. Excluding certain investments through this process could, over time, improve returns through reducing the risk of costly scandals or bad publicity and punishment derived from poor practices.

The broader principle of ‘sustainability’ prioritises companies likely to endure through embracing good governance and environmental and social practices, while filtering out that could fall foul of social, environmental and legislative changes. Recently, for instance, there has been increasing focus on the ‘S’ in ESG as companies’ treatment of customers, staff and suppliers have come under increasing scrutiny during the widespread closure brought about by Covid-19.

What’s more, as we become more acutely aware of the need to solve environmental and social issues, companies that help us do so are well placed to grow. This could be from the opportunities that arise from the creation of a more sustainable and low-carbon economy, or from solving other pressing issues facing society.

While relative returns from different forms of investing ebb and flow, performance numbers do now provide evidence that socially responsible investing needn’t be an impediment to performance. There is no reason why well-managed socially responsible funds can’t be among the best-quality funds available.

Given the variety of approaches, before investing in a fund it is important to read literature carefully. Although a consensus is starting to form around the use of ESG and other terminology in the area, it is still the case that funds may use the same expressions differently. Investors should check that the values of a fund are aligned with their own.

Read more about Socially Responsible Investing

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Socially responsible investments cement longer term outperformance

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