By Luke Oliver, DWS
DWS has long been a champion of environmental, social and governance (ESG) factors incorporated into the investing methodology. While mainstream opinion is that ESG is a niche strategy, we believe responsible investing will continue to grow in prominence. Some investors think ESG factors are difficult to understand. But the main principles of this approach are as simple as A, B, C… An advanced methodology to address systematic risks that can potentially result in ESG funds beating the market. This new norm is coming up fast, as seen by the development of new ESG funds and flows into the space. In other words, ESG investing is really about getting back to the basics. Don’t think of it as a restriction, instead, consider it an additional screen with the potential to offer outperformance.
1. Advanced Methodology
In order to break the mindset that environment, social and governance factors should be applied tactically instead of being mainstreamed, let’s first breakdown the methodologies used in ESG investing. And what best way to address systematic ratings of companies than looking at what the indices are doing? Let’s take for example MSCI’s ESG Leaders indices.
The index provider starts by excluding controversial businesses. Those can range from industries such as gambling and weapons manufacturing, to name a few prominent examples. The second step is to rate and rank companies in the universe based on ten key themes spread across more than thirty ESG issues. Finally, the index uses a top down approach, selecting the best ranked securities and including them in the index at a similar sector weight as the base MSCI EAFE index.
For those wondering what the key issues are, figure one1 goes into more details about each theme. But the real takeaway should be that most of these issues are characteristics that make good, sound investing sense and their integration into valuation methods is long overdue.
In an era where consumers are immersed in digital content, who wouldn’t hold companies accountable for their policies regarding data privacy and security? Let’s take it one step further: who wouldn’t demand a product that seeks safety and quality standards?
2. Beating the Market
The MSCI ratings can reveal characteristics that could have a substantial impact on the performance of a company. In figure two2, the reader can compare the benchmark to the ESG screened index in the emerging market world that intuitively tends to exhibit weaker corporate governance, the difference is stark. The MSCI EM ESG Leaders index (M1EFES)3 has outperformed the regular MSCI Emerging Markets Index (NDUEEGF)4 from a historical perspective consistently in the last 1, 3 and 5 years5 . In fact, the five year outperformance was 2.43%, with just thirteen basis points of additional volatility. The governance factor in ESG can uncover systematic risks that might go unnoticed otherwise and the relative performance of EM ESG leaders against the base EM index shows investors can potentially mitigate the mentioned risks.
Figure 2:
Source: Bloomberg as of September 28, 2018. Past performance may not be indicative of future results. Refer to above and footnote 3 and 4 for index definitions.
The uses of ESG factors of course extend beyond emerging markets. Let’s take the example of Volkswagen. In 2013, MSCI ESG analysis identified concerns with the automaker’s corporate governance, as seen in its practices. By mid-2015, the index provider removed the stock from its ESG Leaders index. Just a few months later, the Dieselgate scandal hit the front page, which led to a significant price decline for Volkswagen shares.
It is interesting to note the company was not removed due to its environmental impact. Though MSCI couldn’t have predicted a scandal would break in that area, the research team identified a change in governance that prioritized returns and did not give a proper consideration of risks of such leadership decisions.
3. Coming Up: A New Norm
Despite a quasi-common sense approach and the potential for increased performance, someone might still wonder whether the time for thinking about ESG has arrived. Clearly, figures three and four6 show that not only assets in ESG steadily grew in the past eighteen years, but also that the offering of ESG funds increased.
Figure 3:
Source: Morningstar as of 6/30/18 Past performance may not be indicative of future results. See footnote 6 for additional information.
Source: Morningstar as of 6/30/18 Past performance may not be indicative of future results. See footnote 6 for additional information.
The potential is amplified when we think that $30 trillion worth of wealth will transfer from baby boomers to millennials in the next two decades. And 90% of millennials want to grow their allocations to responsible investments in the next five years7 .
Bottom Line
An alphabet represents the building blocks of a language, and it may be helpful to think of ESG principles as the building blocks of a practical approach to investing. Environment, social and governance factors are designed to reduce systematic risks, and this may help lead to outperformance when applied across a broad basket of components. This potential for success is observed particularly in markets where governance scores are more varied, though many markets may benefit from additional research and ESG principles. Finally, the focus of the market is changing, and younger generations are more in tune with ESG principles. Learn the basics of this new language now, or risk being left behind as demand for this type of approach seems poised to surge as generational dynamics change.
1 Source: MSCI.
2 Source: Bloomberg.
3 Ticker on Bloomberg: M1EFES Index.
4 Ticker on Bloomberg: NDUEEGF Index.
5 Ending September 2018.
6 Source: Morningstar as of 6/30/18. Data represents U.S. domiciled ETFs and Mutual Funds. Other includes Alternatives, Commodities, and Allocation funds.
7 Source: FactSet’s HNWIs’ Vision for the Wealth Management Industry in the Information Age.