Exchange traded funds and other strategies that revolve around Economic, Social and Governance, or ESG, principles have been quickly gaining traction as investors and advisors incorporate the qualitative benefits of ESG investments into their portfolios.
However, some may question the up-and-coming theme as either a passing fad or a sustainable long-term strategy. So far, the ESG theme has outperformed in recent years.
According to FactSet data, the MSCI EAFE ESG Index has outperformed the benchmark MSCI EAFE Index by over 100 basis points for the past three years ended June 30, 2016.
“Diving deeper, we can see that this effect was driven predominantly by security selection effect,” Ashley Fritz, Portfolio Analytics Specialist for FactSet, said in a note. “One might think that the avoidance of certain sectors would be the chief source of outperformance, but in reality, the companies with higher ESG scores simply performed better than their broad counterparts. Security selection added 91bps, while allocation only added 18bps during the three-year period analyzed.”
Academic research has revealed that strong governance mechanisms have helped diminish default risk and lower bond yields. Barclays also discovered that investment-grade bonds with higher ESG scores outperformed those with low ESG scores over the past 8 years.
The ESG principle are more of a way of living or conducting business that correspond with a firm’s core values. Many companies have defined their corporate social responsibility to account for their impact on the environment and social welfare even if there is no legal requirement.
With these socially responsible parameters, companies may be taking on a long-term business model. In an attempt to head off any environmental and social problems that their operations may create, companies are able to obviate potential regulations and diminish political risks ahead. Moreover, this proactive approach may diminish the risk of conflict with nongovernment organizations and other advocacy groups that can affect sales and brand recognition.
A reputation for social responsibility can also attract and retain talented individuals who are more apt to feel proud of their work.
Furthermore, with a new generation of investors, the younger demographics are more apt to favor companies that address social and environmental responsibilities. These investors will also be prone invest in companies that follow ESG principles as a way to align investment goals with their individual values and philosophies.[related_stories]