Morningstar - Q2 2020 - 57

Strategies

How Does Investing in ESG Affect Returns?
Morningstar research uses a new model
to compare the returns of companies with
strong and weak ESG practices.

E S G FAC TO R

Patrick Wang and Madison Sargis
Investors can build a global portfolio of companies
that have positive environmental, social,
and governance, or ESG, attributes without
compromising returns, according to new
research by Morningstar.
If investors restrict their holdings to only U.S. and
Canadian securities, they will pay a slight price
for holding better ESG securities, the study says.
Meanwhile, it finds no evidence that ESG
holdings reduce or increase the risk of both a
global or U.S./Canada portfolio.
The quantitative study is the most in-depth look
Morningstar has done to date on the
performance of ESG investments. The research
adds to the growing body of evidence that
ESG investors do not have to sacrifice risk or
returns.
Is There a Price to Be Paid for ESG Investing?
One of the key questions surrounding sustainable
investing has long been whether there must
be a risk/return trade-off when considering
ESG-responsible companies.

This concern is logical when viewed through
the lens of popularity. ESG investing has seen
explosive growth over the past few years.
There have been a steadily increasing number of
ESG-focused investment vehicles launched,
accompanied by growing interest from investors.
A record amount of assets are flowing into
ESG funds.

As the market recognizes the value of the ESG
practices of companies, it would follow that good
ESG firms would be priced higher than their bad
ESG peers. After all, the current price of a security
and its future expected return are generally
inversely related. Therefore, the expected return
from a company with good ESG practices
may be lower than that of a company with bad
ESG practices.
In other words, as investors pay higher prices for
good ESG companies, there might exist a
premium in return that induces investors to hold
companies with poor ESG practices. This premium
compensates investors for any ESG-related
risks, such as environmental disasters or corporate
scandals due to governance failures.
Although this makes economic sense on the
surface, we found there is no risk/reward
trade-off to investing in ESG on a global level and
only a slight cost if we limited the universe
to U.S. and Canadian holdings. In addition, we
found that ESG appears to be a distinct investment
factor, meaning that it is either moderately or
not correlated to other known factors.

gSmall Minus Big (SMB) Also known as the size
factor, this measures the historical excess return
of small-cap stocks minus that of large-cap
stocks. It reflects that small companies outperform
large companies in the long term.
gHigh Minus Low (HML) This factor measures
the difference in returns between companies with
high book/market ratios (value stocks) and
low book/market ratios (growth stocks). The name
reflects the pair's observation that value stocks
outperformed growth stocks in the long term.
gMarket Risk
With this model in mind, we created a hypothetical
portfolio called ESG Better Minus Worse,
or ESG BMW. We constructed one portfolio for the
global universe and one for companies based
in the U.S. and Canada.
Each month from January 2009 through May
2019, we ranked every stock based on its

EXHIBIT 1

Comparing Attributes of ESG Portfolios

The global ESG portfolios differed in
market cap, earnings, and dividend
yield, but not in monthly returns.
Portfolio

Market
Cap ($Bil)

Earnings Dividend Monthly
Yield (%) Yield (%) Return (%)

Worse

2.00

5.00

1.30

0.75

Medium

2.75

5.20

1.60

0.78

Better

6.15

5.50

2.20

0.76

How We Evaluated ESG Companies
To determine if there is a risk/reward trade-off
for investing in good ESG companies, we needed
a way to capture an ESG premium or discount.
To do this, we borrowed from the model
established by University of Chicago economists
Eugene Fama and Kenneth French.

With the U.S. /Canada ESG portfolios,
however, monthly return had a slight
inverse relationship with ESG score.

Worse

2.00

4.04

0.51

1.06

Fama and French's model includes three factors
that explain why a stock tends to return more
or less than the market:

Medium

2.82

4.25

0.88

1.02

Better

7.46

4.86

1.70

0.89

Portfolio

Market
Cap ($Bil)

Earnings Dividend Monthly
Yield (%) Yield (%) Return (%)

Source: Morningstar Direct. Data as of 05/31/2019.

morningstar.com/lp/magazine

57


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