Sustainable and Responsible Investing: How to Make It Work

sustainable-investor

An increasing number of investors have committed to integrating environmental, social and governance (ESG) issues in their asset allocation decisions. This is good: we should invest our money according to our values. But if we sacrifice performance along the way, then I am afraid we won't go far in reshaping the asset management industry to allocate capital to companies that are behaving in a responsible fashion.

This is why my co-authors and I set out to understand how we can build a better understanding of the value implications from sustainability investments. You can find the paper here. Our main hypothesis is that the literature, in many cases, fails to find strong evidence of the "do good do well" story because of lumping together sustainability issues that are material and immaterial from an investor's viewpoint. Climate change, employee safety, corruption risk, or product safety all have rather different impact on healthcare, energy, and financial firms.

So we did the following:

1. Followed guidance from the Sustainability Accounting Standards Board (SASB) to classify sustainability issues industry-by-industry to material and immaterial.

2. We constructed portfolios that hold firms with good sustainability performance onmaterial issues and compared to portfolios that hold firms with poor sustainability performance on material issues

3. We did the same thing for immaterial issues.

We found strong evidence that investing in firms that are performing well on materialsustainability issues yields considerably better future stock market performance compared to other firms. Same is true for future accounting performance. The interesting thing is that investing in firms that are performing well on immaterialsustainability issues yields no different performance and even a small under-performance compared to other firms.

These results have important implications for how we think about firms' and investors' capital allocation decisions. Here are some of my thoughts:

1. The work that SASB is doing seems to be quite important helping identify industry-by-industry indeed issues that are important for value creation.

2. More asset managers are using some form of ESG data in their investment decisions. Using aggregate scores is a bad idea. Constructing better performance scores by stripping out the immaterial issues based on industry classification (at the very least) yields much better performance for the portfolio.

3. Since better performance on the material sustainability issues is a leading indicator of future financial performance, companies need to provide high quality information around those issues.

An increasing number of people want to invest their money in a responsible way. Asset managers have now a unique opportunity to start developing truly simple to understand but at the same time value-enhancing products backed by rigorous research.