Lengthening the ESG investment horizon

ESG Clarity Committee member and CIO EMEA for Morningstar IM Dan Kemp looks at past and future returns of ESG portfolios

ESG investors have had a challenging start to 2022 with US equity ESG indices falling sharply and UK equity ESG indices in negative territory while the conventional equivalent remains positive (at the time of writing).

If this recent performance develops into a longer term trend, it is likely to re-ignite the debate about the relative returns of ESG and conventional strategies. It is therefore a good time to remind ourselves why such a debate is both sterile and likely to have little impact on the investors we serve.  

Before digging into this topic, it is worth reiterating the importance of perspective when considering returns. We look back on past returns with utter certainty, as they cannot be changed, and we look forward to future returns with complete uncertainty, as they cannot be accurately predicted. While this point is obvious, it is often forgotten as we use the certainty of hindsight and the patterns we perceive in realised returns to persuade us that the future is predictable. Evidence of this weakness is provided every time we look at past investment performance and find ourselves being drawn towards an investment because of the returns it has delivered, either positive for those attuned to momentum or negative for the natural contrarians.

See also: – Liontrust’s Michaelis: ‘Performance is critical to success of sustainable investment’

Studies of the relative returns of ESG and conventional investments are inevitably focused on the past which has limited relevance for the future. When considering future returns, we must therefore think probabilistically and focus on the fundamental drivers of returns rather expecting a repeat for historic patterns. As we do this, we see that there are three main drivers of returns to investors: The first is the quality of the asset and its potential for future cashflow. The second is the price paid for the cashflow and the third is the weight of each asset in a portfolio.

When considering the prospective cashflow of an asset, the ESG characteristics of that asset are increasingly relevant. As governments and consumers appear more focused on punishing companies with poor ESG characteristics, having a superior ESG profile lowers the risk that future cashflows will be impaired. Consequently, the fundamental outlook for these assets appear stronger.

However, as mentioned above, the fundamental performance of an asset is only one of three elements that determine performance. The second element is the price you pay for those superior characteristics. While we are all familiar with companies that have always appeared expensive but continue to grow so quickly that they look cheap with the benefit of hindsight, these particular examples do not negate the fact that paying a high price for an asset when making an investment is likely to lead to lower returns in the future.

When considering the relative returns of ESG and conventional assets in the future, it is therefore necessary to compare the price one is paying for equivalent cashflow generation. Although this can be done on an asset by asset basis, most investors will hold collective investments that are in some way linked to a benchmark index and it is here that the third element assets itself.

While similar assets may appear in both ESG and conventional indices, their weight may be very different, leading to differing expected returns. This can be most clearly seen in the UK equity market where there are noticeable variations in the composition of ESG and conventional indices. As ESG investors tend to have higher exposure to industries that have performed well over the last few years and are consequently more expensive, future returns are likely to be lower than those of UK investors with a benchmark-orientated conventional portfolio.

Yet, even with this conclusion, the performance debate is sterile because ESG investors, by definition, are looking beyond mere expected returns and are instead selecting an investment approach aligned to their values. As the number of ESG strategies and the data available on them has grown rapidly over the last few years, ESG investors and their advisers are more able to trade off any concerns about expected returns with adherence to the concerns of the investor. This has made a level of personalisation possible that would previously have only been available to the very wealthy. With personalisation comes engagement, and the potential of investors to take a longer term perspective and look beyond recent historic returns. While the impact of ESG investing on the environment and society remains uncertain, any improvement in the lengthening of our investment horizon should be welcomed.

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Natalie Kenway

Natalie is global head of ESG insight for ESG Clarity and has been an investment journalist for 16 years. She won Editor of the Year at the Aviva Investors Sustainability Media Awards 2021, and was Winner...