When ESG Means Alpha

Asset International’s Chief Investment Officer
By Elizabeth Pfeuti
May 8, 2013

Applying environmental, social, and governance (ESG) factors to your investments can actually increase your chances of outperformance, a white paper by German financiers Deutsche Bank has claimed.

Discarding years of research that criticises ESG as a fluffy way for investors to feel good about themselves, regardless of performance, the paper cites evidence that investing in “good” companies will help improve overall returns. [EXPAND Read more]

Dr Andreas G. F. Hoepner, lecturer in banking and finance at Scotland’s University of St Andrews, claims in a paper entitled: “Environmental, social, and governance (ESG) data: Can it enhance returns and reduce risks?” taking this approach is just “quantified common sense”. The paper is published by Deutsche Bank in its Global Financial Institute series.

Hoepner questions why we have seen a rise in ESGinvesting, if there was no practical – or financial basis for it.

“Did all of these investors suddenly understand themselves as eco-pioneers or social campaigners? Some of them might have shifted their understanding, but it is much more likely that many if not all of them have realised the virtues of certain parts of ESG datasets,” he said.

One of the academic’s main arguments is that ESG nay-sayers have concentrated on poorly-created screens that filter out entire sectors and based conclusions on corrupted data.

He claims evidence used by many studies looks across parameters that are too wide, leading to distortion.

“Studies finding that the average ESG integratinginvestment fund does neither outperform nor underperform its conventional peers simply do not address the relevant question, as they ask, ‘How well does the average ESG investment process perform?’ Instead, the key question for the individual asset manager, institutional investor, or retail client is, ‘Can ESG criteria enhance returns on investment processes if implemented sophisticatedly?’.”

Technical implementation is crucial for investment processes, in Hoepner’s view.

He asks whether ESG datasets should be included on a wider analytical level, citing labour happiness (thus retention and productivity) and energy consumption (thus costs and potential levies) as important factors to consider when stock picking.

Hoepner quotes a study in 2007 from the University of Cologne, which chose best-in-class companies – including their ESG factors – and outperformed better than companies picked by strategies that merely adopted a negative screening method.

In this instance, he said, ESG investing could produce outperformance.

Finally, the paper hits back at critics who claim ESG factors are neutralised at a portfolio level, adding that diversification is improved by including them.

“As firms with good ESG ratings are associated with lower asset-specific (that is, firm-specific) variances, integrating ESG criteria in investment processes can enhance portfolio diversification.”

Hoepner concludes: “This white paper introduces the concept of ESG investing as a fresh breeze of quantified common sense in the investment world. It highlights the opportunities of ESG investment to enhance investment returns and reduce investment risks.”

With signatories to the United Nations Principals for Responsible Investment representing more than $30 trillion, Hoepner is not alone in his beliefs. [/EXPAND]