Does investing responsibly deliver alpha?

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As it turns out, doing the right thing does pay off. Despite a widespread perception that responsible investing (RI) means sacrificing returns, recently released data from the Responsible Investment Association (RIA) show that RI-focused investment funds outperformed traditional Canadian, U.S., and global equity funds in 2020 and over the past three-, five- and 10-year periods.

In most cases, the difference is as small as a couple of basis points, but the gap is as high as 5 percentage points for U.S. equity RI funds over the past three years (16.3 per cent versus 11.3 per cent).

RI investment funds fall under a broad definition that incorporates various strategies, but most recently, investment fund managers are focusing on seeking out companies with responsible environmental, social, and governance (ESG) practices.

“They are funds that are not only marketed as ESG, sustainable, or responsible, but they also need to have supporting policies in their regulatory documents such as the prospectus and Fund Facts,” says Dustyn Lanz, the RIA’s chief executive officer.

He adds that the study confirms a long-held conviction that investing responsibly is a smart investment strategy.

“The past year has shown that ESG can be good for performance, but many ESG funds have actually been performing well for years. Academic research showed us back in 2015 that funds with a focus on ESG perform just as well if not better than traditional funds,” Mr. Lanz says.

Conventional investing wisdom often assumes that the restrictions around investing in an ESG-focused manner put RI investment fund managers at a disadvantage to their colleagues who have almost unlimited access to global equity markets.

There is no clear reason why RI investments are outperforming, but with investors taking a more long-term view on environmental sustainability and governments forcing companies to comply with new environmental standards, capital will continue flowing toward companies that put a focus on these factors, Mr. Lanz says.

“It’s borderline common sense when you think about it. A company is more than just the numbers. If it’s well-governed, managing its exposure to social environmental risks, and tapping the opportunities, then there’s a good chance we’re talking about a well-run company”, he says, adding traditional polluters in the resources sector are even getting the message.

“We are now seeing commitments from companies like BP [PLC BP-N], Cenovus [Energy Inc. CVE-T] and Repsol [SA REPYY] to achieve net-zero greenhouse gas emissions. They are doing it because they know the game is changing and they have to get prepared,” Mr. Lanz says. “Access to capital is going to be the big transformative lever for the transition, particularly with respect to the energy sector.”

But not all investment research shows that ESG has outperformed the broader market over the long term. Scientific Beta Pte, a “smart beta” index provider based in Singapore and linked to the Edhec Research Institute, recently published a white paper in which it says that there’s no evidence that supports ESG can deliver outperformance. Furthermore, it points out that current analyses are flawed because they focus on the wrong metrics, such as high profitability.

Ian Tam, director of investment research at Morningstar Canada, which partnered with RIA for its research, says it’s clear that ESG funds outperformed the broader market in the midst of the pandemic, but adds that measuring the success of RI investments can be arbitrary because the criteria for determining performance might differ.

“The advantage in using ESG in your investment process is that it may pick up qualities of a company that are not reflected in traditional financial metrics that may take a little longer to play out,” he says, adding that their relative newness to the market also makes performance hard to read.

“The number of sustainable products has really ballooned over the past three years in Canada, so that’s going to skew the results. You’re going to have a couple of funds that have been around for 10 years, but the majority of them were just born recently,” he says.

One advantage for RI funds that he says is hard to measure is not having the long-term risk burden that traditional funds carry by owning companies that don’t comply with ESG mandates such as diversity on their boards of directors.

“What is going to impact the company materially over time financially if it doesn’t have the right corporate policies in place?” he says. “Those types of risks are not always going to play out right away.”

As the world turns to sustainability – willingly or forcibly – the success of corporations will depend on their ability to seek and attract innovation, which will ultimately lower costs and increase profits, Mr. Tam says.

“The whole idea with ESG investing is to direct the flow of capital to companies that are managing their ESG risks actively or responsibly,” he says.

While he doesn’t see clear evidence of ESG funds outperforming their peers over the long term just yet, Mr. Tam expects returns to improve as fund providers engage with companies, informally or through proxy voting, to implement ESG policies.

“That type of influence will hopefully draw more attention to companies that have better policies in place and that extra capital will allow them to innovate in more ways,” he says.