The further we go back in time, the more likely it is that the scoring data does not adequately capture real-time ESG challenges.

A version of this article was first published in December 2021 and has since been updated.

How does incorporating information on environmental, social, and governance (ESG) risks affect the performance of a portfolio? Does considering these issues put a portfolio on a better footing to cope with a changing world and enhance returns? And what about aligning values with investment decisions – does ‘doing good’ with your capital come at a cost?

What about volatility? Does accounting for a wider range of future risks reduce the bumps in portfolio performance? Or, by excluding sectors and companies, do we end up with a more concentrated and therefore more volatile portfolio?

In this piece, we look at this deeply complex issue by investigating past data and discussing its limitations, particularly in predicting future performance. We also consider whether changing consumer preferences and evolving regulatory and policy initiatives to tackle ESG issues might mean that investors who are ahead of the change might be expected to see portfolio benefits.

Historically difficult to test

Empirical back-testing to gauge relative performance is fraught with practical difficulties, largely due to the lack of quality historical data on which to score companies. The primary issue with back-testing relates to how to score a company on its E, S and G characteristics. There are external ratings agencies that provide company ‘scores’ on these metrics, but this data is subject to three main limitations.1

First, scoring methodologies can be opaque and subjective, and different providers often produce conflicting scores. A well-known electric vehicle producer is an oft-cited example: different weights assigned to environmental and social credentials can lead to different conclusions about the firm’s overall sustainability characteristics.

Second, coverage of companies isn’t always complete, and can be particularly sketchy for smaller firms and fixed income issuers. In emerging markets, language issues can also be a barrier to the collection of accurate data.

Finally, the further we go back in time, the more likely it is that the scoring data does not adequately capture real-time ESG challenges. The data may not have been available or disclosed at the time and, more importantly, the data that is actually relevant to asset pricing has likely changed over time. Twenty years ago, governance may have been the most relevant non-financial metric for assessing the sustainability of corporate performance. Today, environmental issues are in sharper focus, as are social issues such as workforce diversity.

Market leadership and short-term sustainable returns

Rather than tilting a portfolio based on ESG scores across all sectors, some investors may prefer to focus on risk mitigation by excluding certain industries or sectors to reflect their sustainability preferences. At certain points in the economic cycle, excluding specific companies – such as gambling, tobacco, nuclear power, weapons, alcohol and energy firms – for sustainability reasons can have meaningful implications for relative performance. Most obviously, excluding traditional energy companies from a portfolio will likely lead to outperformance when oil prices are falling, but potential underperformance when oil and other energy prices are rising. If energy accounts for a large proportion of a benchmark, the relative impact is even greater. Looking at the impact of excluding energy in the UK (where the sector currently makes up over 13% of MSCI UK) vs. the US (where energy comprises 4% of the S&P 500) during the recent energy price rollercoaster demonstrates this point (Exhibit 1).

In addition, companies that do not have good long-term growth opportunities or ESG scores can still generate good financial returns when profits are returned to shareholders or when there is a grab for yield. A notable example is American tobacco companies, which have delivered a total return of 12.3% annualised over the last 20 years to 31 July 2023, compared with 10.1% for the S&P 500 (based on Refinitiv Datastream data). Of course, for many investors, any return sacrifice may be entirely acceptable given their broader investment ambitions beyond financial returns.

Factor rotations within the market are another element that can influence the short-term performance of sustainable strategies, many of which are often tilted more towards Growth rather than Value. Climate technology stocks are a good example. With the vast majority of these companies’ profits expected to be delivered several years down the line (thanks to technological breakthroughs that are yet to take place), they tend to be more sensitive to changes in interest rates. Periods where interest rates are falling can therefore result in these types of stocks performing very strongly, and vice versa. Recent history indicates this clearly, with a boom in clean energy stocks coinciding with central banks slashing rates in 2020, before rising inflation and central bank tightening brought valuations back to earth (Exhibit 2).

The asymmetries in fixed income

On top of the issues described above, it is worth spending a moment thinking about ESG, returns and fixed income. Ordinary shares do not have pre-defined time horizons, so for an equity investor the return depends on the payout prospects over the whole life of the asset. In contrast, a fixed income investor holding a bond to maturity is primarily concerned about receiving the agreed coupons and then having their principal returned over a fixed time horizon, creating an asymmetry.

For example, consider a company that is on the right side of a new government announcement, for example, the producer of an alternative to single-use plastics after an announcement of a ban on single-use plastics. The stock investor sees a jump in the stock value, reflecting the enhanced outlook for long-term profits. A bond investor planning to hold the bond to maturity would not see an enhanced coupon or dividend, and so would not receive the same benefit from the announcement.

Now consider the company that is on the wrong side of a government announcement, with the long-term viability of its current business model challenged. The stock investor loses out immediately. Whether the fixed income investor loses out over the lifetime of the bond depends on whether the coupons or principal are at risk. This may not be the case on a very short-dated bond but would more likely be threatened on a longer-dated bond.

Given this asymmetry, incorporating ESG risks in a fixed income portfolio might be expected to affect returns. Considering ESG issues can limit downside risk in a portfolio by capturing a broader range of potential sources of default risk. However, it could lead to underperformance if issuers who are riskier on the sustainability front do not default within the time horizon of the bond and therefore investors have forgone the higher spread that resulted from the pricing in of that risk.

In addition, as with equities, high yield bonds in the energy sector will likely underperform when oil prices fall and outperform when they rise, so ESG exclusions can lead to periods of underperformance as well as outperformance. Again, in both instances, any return sacrifice may be entirely acceptable to investors who are seeking sustainable outcomes as well as financial returns.

Most importantly, history is unlikely to be a guide to the future

Even if it was possible to draw firm conclusions using historical index data, we would argue that history is unlikely to provide a useful guide to the future. That is because the sustainability issues that we expect to drive markets are still in their infancy.

Below we list four specific areas in which we believe ESG considerations have the potential to create market winners and losers:

1. Government ambitions and regulatory policy
Encouraged by the demands of their electorates, governments are increasingly focused on tackling issues such as social injustice and climate change. Policymakers have a variety of sticks and carrots at their disposal to drive change. One example of a ‘stick’ policy being used to tackle climate change is carbon pricing, which exerts a cost pressure on less energy efficient companies. An example of a carrot policy is a scrappage scheme that encourages consumers to dispose of petrol-fuelled cars for electric vehicles. We recently reflected on the impact of government policy on the energy sector.

Clean energy stocks are often some of the most exposed to new announcements given the direct impact that a shifting government stance can have on these companies’ future growth and profitability. Yet as policy evolves to force markets to better reflect the externalities associated with climate change, the impact on company earnings is likely to be seen across all sectors.

2. Disclosures
Central banks, regulators and governments are increasing transparency around ESG risks by forcing companies to disclose more sustainability-related information about their businesses, from diversity statistics and pay of their employees to carbon emissions. This allows both consumers and investors to make more informed choices. Policy in this area is moving quickly, with the EU’s Corporate Sustainability Reporting Directive (CSRD) the latest example that will require almost 50,000 European companies to provide detailed disclosures on a wide range of ESG issues.

3. Consumer choices
Attitudes and behaviours among consumers are changing rapidly, with potential consequences for the long-term profitability and market performance of companies. Areas where consumers are having a significant impact range from specific preferences (such as the increasing rejection of single-use plastics) to reputational risk from poor corporate ESG choices. The latter is of escalating importance given that intangible capital (brand) is an increasingly large component of many companies’ market value, but there is already evidence to highlight how consumer perceptions are impacting companies’ top lines (Exhibit 3).

4. Central bank policy
While government policy is having a growing influence on the macro landscape, central banks are being asked to support these endeavours by ensuring that private capital forms part of the solution. Increasingly, central banks are having green targets added to their mandates. They can target these green mandates through two channels: 1) they can use their regulatory levers to direct capital towards higher scoring companies (for example, through pension fund requirements), and 2) they can tailor their balance sheet management to favour climate friendly companies and sovereigns. Isabel Schnabel, member of the European Central Bank’s executive board, explicitly highlighted the balance sheet as a tool to drive change during a 2023 speech in which she stated that “green targeted lending operations could be an instrument worth considering when policy needs to become expansionary again.”


Evolving perceptions of ESG issues and a lack of high-quality historical data make it difficult to demonstrate conclusively the extent to which E, S, and G risks have affected past performance. However, even if it was possible to make a definitive statement on this topic, we would nonetheless be cautious about using historical results as a guide to the future.

We expect the ongoing shifts in government policy, regulation and consumer preferences to continue to change the macro landscape and consequently impact markets. We are also starting to see a shift in how exclusionary frameworks are being applied, taking into account transitioning companies and using climate scenario analysis to better assess whether issuers are “fit for purpose”. It is by being ahead of these developments in the coming years that we see the potential for investors to generate enhanced portfolio returns.

1 Some ratings agencies do provide an ‘ESG Leader’ index. However, these indices are often constructed with an overarching ambition of having a low tracking error to the market benchmark. While this shows that it is possible to construct a portfolio that has a better ESG outcome than the benchmark without giving up performance, that is a separate question from asking whether an unconstrained ESG strategy can outperform.
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