How ESG Investing Leads to Value Creation

During the last two decades, a number of studies have examined the financial impact of environment, social justice, and corporate governance (ESG) and socially responsible investing (SRI) strategies on corporate profitability and equity performance.

Recent research demonstrates that the market cares about the socially responsible behavior of firms. The ESG investing sector is now estimated to have $17 trillion in assets in investment vehicles that include mutual funds, separately managed accounts, and over 755 ETFs, according to the site ETFdb. Based on the available data, ESG investing of $17 trillion now accounts for about one-third of all professionally managed assets as of the end of 2019.

The biggest issue of interest to ESG fund managers is corporate political activity followed by labor and equal employment opportunities at the corporations in the portfolios,   according to the Forum For Sustainable and Responsible Investment.

These two top issues for the 2018 to 2020 period should be of interest to Republicans, who are especially critical of labor rights and how corporations should refrain from entering the political arena. Apparently, the corporations are bucking both of those suggestions by Congressional Republicans.

Standard & Poor’s has created the S&P 500® Environmental & Socially Responsible Index to measure the performance of securities from the S&P 500 that meet environmental and social sustainability criteria from a monthly to a ten-year snapshot. Consequently, corporations are channeling significant resources to improve their relations with key stakeholders, such as shareholders, employees, customers, and suppliers.

While the number of ESG and SRI funds and ETFs is growing, the concept of responsible corporate behavior is not new. The origins of ESG-type funds date back to the Quakers and their Religious Society of Friends who in their 1758  Philadelphia Yearly Meeting prohibited members from engaging in the slave trade.

A 2016 report from The Forum for Sustainable and Responsible Investment, found that most of the ESG asset growth was fueled by Millennials who had a preference for ESG-linked investments.

Early Academic Papers Predicted ESG Growth 

Given this significant market size, a number of studies conducted by academics and professional investment firms have examined the financial performance of corporations that follow ESG initiatives worldwide. All this was done in an attempt to answer the complex questions: does ESG lead to firm-level efficiencies, value creation, and improved equity market performance, and if so, in what ways?

A 2009 review by J.D. Margolis, H.A. Elfenbein, J.P. Walsh, in the paper, “Does it pay to be good and does it matter? Meta-analysis of the relationship between corporate social and financial performance,” (Working Paper, 2009) of 251 academic papers found there is “a mildly positive relationship” between CSR corporations and positive financial performance “such that the median and weighted average effect size of CSR on firm financials are lower than the mean effect size. Thus, the mean is inflated by large effect sizes of a small number of studies that used a relatively small sample of companies.”

ESG also has another attraction. A 2013 Nielsen study (cited in the paper, (Journal of Business Research, Volume 84, March 2018, pp. 206-219) that found customers worldwide are willing to pay higher prices for products and services that reflect CSR values, more research is needed to establish “the causal mechanism between CSR and a firm’s financials.”

Companies that follow ESG practices also offer a better window for equity analysis and risk management. At the individual company level, a February 2017 report by the $224 billion hedge fund AQR, found that corporations that follow ESG practices have made better investment decisions that improve financial performance.

This report found that “overall, our findings suggest that ESG may have a role in investment portfolios that extends beyond ethical considerations, particularly for investors interested in tilting toward safer stocks. ESG exposures may inform investors about the riskiness of the securities in a way that is complementary to what is captured by traditional statistical risk models.” For example, the paper noted that companies with good governance practices have a strong correlation to positive future returns.

Another paper, When and how is corporate social responsibility profitable? (Journal of Business Research, Volume 84, March 2018, pp. 206-219) concluded that while there are many layers to how ESG decisions are made inside corporations and how they are viewed by stakeholders, “Unfortunately, notwithstanding its strategic benefits, the empirical findings regarding the impact of CSR on firms’ financials are mixed.”

Traditional branding practices have found that a customer’s expectations about a service or product are impacted by brand connotations, symbolic elements, advertising, and other communications. CSR practices give corporations new ways to differentiate themselves and offer more ways to communicate with stakeholders. As a result, they add to value creation.

At the institutional level, ESG investing plays a role in strengthening the long-term investment prospects of pension funds.

A report by the International Transport Workers’ Federation found that “core labor standards are being upheld by two-thirds of the 100 largest funds in Europe,” including pension funds representing a massive EUR 2 trillion, who refuse to invest in companies identified as having anti-labor business practices. As a result, pension funds are acting to protect those workers’ rights ahead of retirement in the form of responsible investment policies by pension funds.

So while the relationship between corporate ESG practices and value creation continues to be studied, institutional investment managers, individual investors, consumers, and corporations seem to be embracing socially responsible business practices.