ESG has been positive for returns

While some portion of this performance may relate to the temporary effect of increased flows, there are good reasons to believe that sustainable investing brings more lasting benefits. In many respects, companies that score well on ESG metrics also align with the broad “Quality” factor – sharing higher return on equity and lower observed volatility.

Integrating ESG factors can generate long-term outperformance

Exhibit 3: Higher ESG scores have been consistent with stronger investment performance

Source: J.P. Morgan Asset Management; data as of June 30, 2021. Past performance is not a guide for future performance.

From exclusion to inclusion

Despite growing evidence to the contrary, some investors still assume that ESG considerations impose a drag on performance by limiting the investment opportunity set, reducing diversification and excluding some otherwise attractive investment opportunities. This outdated view was more relevant to socially responsible investing (SRI) – an earlier form of what has evolved into ESG – that was built around rigid criteria to exclude non-compliant firms.

SRI investors imposed their views within portfolios bluntly: broad exclusions on companies engaged in business activities deemed to be objectionable, even in cases where the objectional activity was only a small part of the overall business. The result was predictable: companies, and even whole industries, were ruled out of bounds, leaving the the portfolio less diversified and usually delivering lower returns. The lost return potential may have been less important for many investors than the principle at stake, and they knowingly bore the cost of this trade-off.

Modern sustainable investing, in contrast, tends to take a more nuanced and inclusive application of ESG metrics to the security selection process. This begins with a public and transparent ESG scoring system, such as the widely followed MSCI ratings, that ranks companies in the public markets across a range of environmental, social and governance metrics – providing a numerical score for each sub-category, as well as the overall enterprise (Exhibit 4).

ESG scores are widely distributed

Exhibit 4: Distribution of ESG scores by region

Source: MSCI, J.P. Morgan Asset Management; data as of April 11, 2022.

A key benefit of this model over the more exclusionary SRI framework is that it does not establish a strict “bright line” criterion for eligibility, but rather allows for a relative ranking of companies against one another. It also allows investors to seek increased ESG metrics across a broadly diversified portfolio or tilt their strategy towards particular criteria (E, S, or G) that may be more or less important to them.

Sustainability metrics can be tailored to address sector-specific criteria

Exhibit 5: Internal composition of ESG score for specific sectors (total for each sector is 1.0)

Source: J.P. Morgan Asset Management; data as of June 30, 2021.

Sustainability within a Strategic Asset Allocation

Asset allocators remain focused on return targets and risk budgets. However, the growing availability of sustainable investment strategies across most asset classes ensures that building diversified asset allocations is largely unaffected by the decision to incorporate ESG. The market continues to evolve and investors are able to access numerous types of sustainable strategies. Some examples include:

Looking to the future, achieving higher aggregate ESG scores across the full asset allocation may become a more common objective for institutional investors. To increase flexibility, investors can blend allocations to achieve their overall target. For example, investors could use high-scoring strategies to offset sectors elsewhere in the portfolio that have low ESG scores but offer high returns. This could be a particularly compelling attribute of thematic or impact strategies, which might be valued as much for their ESG score as for their intrinsic return potential.

Changing the future through capital allocation

Until very recently, the allocation of capital by institutional investors could be described between the X and Y axes of a risk and return graph. The investment world expended a great deal of time and effort to understand and quantify the behavior of portfolios within these dimensions; it devoted less time and effort to understanding how this process affects the world at large.

Today, investors are not only aware of the broader impact of their decisions, they are starting to realize that they possess agency to shape the future as well. Sustainable investing is a direct response to visible flaws in the capital allocation process which have created and perpetuated negative consequences – from climate change to inequality.

Few forces at our disposal have the power to impact the future more directly than capital allocation. The recipients of capital thrive and those who are starved of capital fade away. Choices made by long-term investors today will have consequences not just for the next quarterly performance report, but across our economy and society for years and decades to come.

Investing on the basis of sustainability/ESG criteria involves qualitative and subjective analysis. There is no guarantee that the determinations made by the adviser will align with the beliefs or values of a particular investor. Specific assets/companies are not excluded from portfolios explicitly on the basis of ESG criteria. Sustainability issues are identified and quantified as part of our investment due diligence process, not only as a pre-requisite for responsible investing, but also as a tool to help mitigate potential risks.

09rd221305082731