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The returns and fundamentals of ESG integrated investing

06th May, 2020 part of a series of insights, Davy Global Fund Management (DGFM) explains some of the fundamental benefits of integrating Environmental, Social and Governance (ESG) into Global Equity funds. One of the fundamental benefits of ESG integration is performance. We would like to explain in more detail what we mean by performance and how we can show that ESG integration is an important driver.  This is a relatively new and sometimes complicated area of investment which, of late has seen much debate from academics and investment professionals. In our previous insight (DGFM Explains the Growth of Responsible Investing) we highlighted issues surrounding the reliability of ESG data and the motivations for pursuing an ESG integrated strategy.  We also highlighted the issues faced when representing investment benefits, including; alpha generation versus a market benchmark, risk diminution or improvement in fundamentals.

Empirical research has been broadly supportive of the notion that ESG does not harm investment returns. A meta-analysis of over 2,200 studies found that ESG did not adversely affect investment returns in 90% of cases, with ESG adding value in most cases, Friede et al.

Many existing studies such as Clark, G, A. Feiner and M. Viehs2  examine the linkage between ESG considerations and stock returns have focused on studies of mutual fund returns. There are many issues with this approach. For one, self-identification or external categorisation can group funds which fall under values-based or impact-based approaches. This is inadequate for many reasons.

Firstly, values-based approaches are typically heterogeneous and not easily grouped. Also, values-based approaches exist due to investor preferences and not as a means of generating additional returns. As such, research in this area has typically focused on how reducing the opportunity set can negatively impact returns, Hong & Kacperczyk3.

Secondly, the performance of mutual funds can typically be explained by factors outside ESG, such as specific factor exposures or security selection issues. For example, thematic or impact-based approaches often carry large factor exposures which influence returns radically.

The Friede study referenced above attempts to cover the broadest possible number of studies to get a directional sense, in aggregate, of whether ESG adds value or not. To corroborate the Friede findings, we examine in this insight whether naively investing in higher-ESG rated stocks adds value by measuring alpha contribution of a group of high-ESG companies in comparison to the broad market. This represents a common-sense approach to a complex question. It is worth noting that we deem consider a stock to be of higher ESG value if it is rated higher on the MSCI ESG scale which rates equities using a 7-point scale from the best AAA rating to the worst CCC rating.  

1. Methodology

In the interest of combatting the issue of consistency around ESG data, throughout this study we rely on the data of MSCI ESG, as an industry-leading provider of company ESG research and ratings. We view the MSCI approach as the most consistent framework available and one which closely mirrors the Sustainability Accounting Standards Board’s4  focus on industry-specific, financially material business risks. Materiality is a vital concept in establishing the relevance of ESG data for a given company or sector, providing a linkage between operational performance and ESG performance, Khan, Serafeim and Yoon5. For example, under this approach, financial institutions are more vulnerable to data security or people management risks than their direct environmental impact risks, unlike an energy company which is more vulnerable to environmental risks.

Also, the use of independent ESG ratings provides an objective basis for our study, echoing the approaches of other ESG studies, such as Dunn, Fitzgibbons and Pomorski6 . MSCI’s ESG ratings work on an S&P-style scale, working from AAA (best) to CCC (worst). All performance data is calculated in US Dollars and runs until 30th September 2019.

Table 1: MSCI ESG rating classifications7

Table 1

Source: MSCI ESG 

Warning: The factors listed here are neither comprehensive or exhaustive

The MSCI World Index is used as a basis, representing the broad global developed market. The MSCI ESG Leaders Index is used as a proxy for companies which rate highly in ESG terms. The MSCI ESG Leaders Index has been chosen on the basis that the index is constructed using a broadly similar methodology to the MSCI World Index, with sector and regional biases neutralised relative to the benchmark index, minimising other possible pollutant factors into the study. The MSCI ESG Leaders Index only selects the highest 50% of the market capitalisation of each sector and region of the MSCI World Index, making it highly comparable to its parent index. 

Table 2: Comparison of indices used in study

Table 2

Source MSCI

One caveat to note is that the sector and region-neutral nature of the MSCI ESG Leaders Index, relative to the MSCI World Index8 , results in a very low tracking error9  (1.2% tracking error over 10 years, to 30th September 2019). The net effect, given the similarities between the MSCI World Index and MSCI ESG Leaders Index, is that differences observed in the study tend to be small, but nonetheless can be insightful.


2. Results

Figure 1. Performance of MSCI World Index versus MSCI ESG Leaders Index over annualised periods

Figure 1

Source: MSCI, Davy Global Fund Management, as at 30 September 2019 gross annualised (USD). The benchmark index shown above does not include fees or operating expenses and you cannot invest in it. 

When comparing the MSCI ESG Leaders Index with the MSCI World Index, we see as shown in Figure 1 above, that in the very short term (1yr), the MSCI ESG Leaders Index has outperformed the broad market index. This effect disappears in the medium term (3yr and 5yr) and has a negative effect in the longer term, as the MSCI World Index outperforms the MSCI ESG Leaders Index

Figure 2. Annual relative performance of the MSCI ESG Leaders Index versus MSCI World Index

Source: MSCI, Davy Global Fund Management, as at 30 September 2019 gross annualised (USD). The benchmark index shown above does not include fees or operating expenses and you cannot invest in it. 

From 2009 to 2012, we see pronounced underperformance from the MSCI ESG Leaders Index. In the period 2013 to 2017, we see performance broadly in line with the MSCI World Index, and then in 2018 and the year to date 2019, we see outperformance in the MSCI ESG Leaders Index. While it would be presumptuous to make a large inference based on 21 months of data, this would suggest that if there is an ESG premium, it is a very recent phenomenon.

We believe that the more recent outperformance can be explained by the evolution of ESG research and demand-driven factors;

  • Demand-driven factors: the increasing popularity of ESG has led a confluence of demand-driven factors, such as the growth of passive ESG approaches, the development of active approaches driving clustering in higher ESG names and the avoidance of ESG laggards for fear of reputational risk among asset managers.
  • Data Quality: ESG, as a field, is less evolved and faces constant development as data quality improves and disclosure becomes increasingly standardised. As ESG research evolves it becomes increasingly useful to investors, therefore increasing adoption rates among investors.

Whilst we believe that our approach neutralises some of the previously listed issues with ESG data and studies involving ESG we note that they may be some flaws with this approach;

  • As mentioned earlier, ESG research has evolved over time and so have the methodologies used to compile ratings. As such, the criteria used to evaluate a best-in-class ESG stock in 2009 versus 2019 have changed considerably. For example, the consistent alignment of ESG with material business risks is a reasonably new and developing area.
  • The broad-brush approach employed here ignores the fact that ESG leading stocks also appear in the MSCI World Index, creating duplication between the two indices. This is demonstrated by a tracking error between the two indices of 1.2% over a 10-year period. Given benchmark similarities, significant observations may be difficult. 

To effectively assess the viability of ESG requires the comparison of high and low ESG stocks. Ideally, there would be a publicly available index with a suitably long track record for stocks with worst-in-class ESG track records. This would allow comparison of two discrete portfolios with contrasting ESG profiles. In response to this, we examine the performance of MSCI defined AAA-rated stocks (highest ESG) vs CCC-rated stocks (lowest ESG) to see if ESG does add value in extremis. 

Figure 3. Performance of AAA-rated versus CCC-rated stocks 

Figure 3


Source: MSCI ESG, Davy Global Fund Management, as at 30 September 2019 gross annualised (USD). The benchmark index shown above does not include fees or operating expenses and you cannot invest in it.


Figure 4. Calendar year performance of AAA-rated versus CCC-rated stocks 

Figure 4


Source: MSCI, Davy Global Fund Management, as at 30 September 2019 gross annualised (USD). The benchmark index shown above does not include fees or operating expenses and you cannot invest in it.

We see from the data in the above figures that AAA-rated names, those distinguished for having a particularly high level of awareness around their ESG risks, have significantly outperformed those rated CCC from 2017 onwards and in particular in 2017 and 2019 (YTD). However, as we can see from the table below, the relationship between ESG ratings is far from linear, with AA-rated names (the second highest notch) underperforming several lower ESG notches (BBB, BB, B). The table below displays the performance data in a way that you can compare relative performance across all ESG ratings, as you can see in the extremes (AAA and CCC) there is a positive correlation but in the middle rated stocks there can be times when a BBB rated stock could outperform a BB.  


Table 3: Relative percentage return for each ESG rating grade over an annualised three-year period



Table 3

The data above would imply that the avoidance of the very worst companies (CCC-rated) is as important as selecting the best companies (AAA-rated). However, we would note that there are several issues with this approach.

The primary issue with this finding is the short time span which we are focussing on (less than four years). Also, we observe sector and regional biases are not fully neutralised within the comparison of AAAs and CCCs and thus other external factor exposures may play a role. We consider this data promising, but inconclusive, and will continue to monitor this over time.
Many other studies have attempted to draw a correlation between high ESG stocks and sustained positive investment performance. However, it is our view that the flaw in these studies is that correlation does not necessarily imply causation, and the effects observed may be explained by ESG’s relationship with other high-performing factors, Kruger10 . Future research should focus on methods of causation over correlation and place greater emphasis on how ESG may impact returns.

One answer to unlocking how ESG data adds value may lie in the examination of ESG’s relationship with company performance according to fundamental data. If there is a substantive benefit to the integration of ESG criteria, we should be able to see this reflected in the fundamental characteristics. This approach comes closer to answering questions around causality and how ESG impacts returns. 

A common question we hear from investors centres around the capital efficiency of high-ESG rated companies. The implication is that ESG requirements create a plurality in the priorities of management, diverting attention away from financial returns and resulting in lower capital efficiency. Intuitively, this implies that more sustainable (ESG-friendly) approaches result in higher operating costs or an acceptance of lower returns. However, interpreted differently, more sustainable approaches may in fact allow businesses to increase prices more liberally, may engender greater customer loyalty or increase operational efficiency, e.g. fewer workplace accidents. 

Note: This chart should be read as relative percentage return. For example, AAA minus percentage return of CCC is -8.34 

Source: MSCI, Davy Global Fund Management, as at 30 September 2019, gross annualised (USD). The benchmark index shown above does not include fees or operating expenses and you cannot invest in it.

Figure 5: Annual gross margin performance for MSCI World and MSCI ESG Leaders Indices

Figure 5


Source: MSCI, Davy Global Fund Management, as at 30 September 2019 gross annualised (USD). The benchmark index shown above does not include fees or operating expenses and you cannot invest in it.


Figure 6: Annual operating margin performance for MSCI World and MSCI ESG Leaders Indices

Figure 6


Source: MSCI, Davy Global Fund Management, as at 30 September 2019 gross annualised (USD). The benchmark index shown above does not include fees or operating expenses and you cannot invest in it.


Figure 7: Annual Return on Assets for MSCI World and MSCI ESG Leaders Indices

Figure 7


Source: MSCI, Davy Global Fund Management, as at 30 September 2019 gross annualised (USD). The benchmark index shown above does not include fees or operating expenses and you cannot invest in it.


Figure 8: Annual Return on Equity for MSCI World and MSCI ESG Leaders Indices

Figure 8


Source: MSCI, Davy Global Fund Management, as at 30 September 2019 gross annualised (USD). The benchmark index shown above does not include fees or operating expenses and you cannot invest in it.


The data observed using the comparison of the two indices implies that high-ESG rated companies generate higher margins (gross and operating) and returns (based on equity capital and assets) than the broad market. The implication is that high-ESG companies, based on operating margins, are more operationally efficient than the broad market. From this data, this gives lie to the notion that high-ESG companies accept lower quality fundamentals in exchange for ESG piety. Rather, the higher-quality fundamentals imply that that high-ESG companies allocate capital in a more positive manner than the broad market, possibly owing to a longer-term horizon and a greater appreciation of inherent business risks.

3.    Conclusion 

Based on the data above our findings on the topic of whether ESG integration has return benefits would indicate that ESG does not destroy value. However, the data indicates that ESG has not added significant long-term value in investment returns either. When we compare the gross returns of MSCI ESG leaders versus the MSCI World Index the “best” rated ESG stocks have outperformed the “worst” rated in recent years. However, it is too soon, and our conclusions are based off insufficient data to fully extrapolate the superiority of ESG stocks on this basis. Equally, it may not be enough to naively buy ESG companies in the expectation of improved performance. The consequence is that passive investment approaches may be insufficient in identifying those investment opportunities likely to generate a positive return from ESG integration.

The higher fundamental characteristics of high-ESG stocks as compared to the broad market as shown above may support a potential relationship between ESG and investment quality. However, there is an element of chicken and egg to this relationship; are higher rated ESG companies operationally superior to their peers or are high quality companies, by virtue of their higher returns and margins, better able to reinvest in improving their ESG credentials? This issue of causation or the explanation of a method of action should be addressed by future research. In practical terms, the concept that a company will provide greater returns and higher margins in the future based singularly on a higher ESG rating appears overly dogmatic. ESG research ultimately requires the additional context provided by broader fundamental analysis to make any larger inferences on the future profitability of a company.


About DGFM

At DGFM, we believe that Quality as an investment style is strongly complemented by ESG research, potentially offering a justification for sustainably better fundamental characteristics. We follow an investment philosophy based on our own definition of Quality. Based on the firm’s definition of QUALITY11 , a proprietary model has been developed founded on the four pillars of Profitability, Persistence, Protection and People, whose effectiveness is supported by in-house back testing.

We view responsible investing as a key part of our fiduciary duty to our clients. Fundamentally, we view a company’s ability to manage its environmental, social and governance (“ESG”) risks as representative of how it manages its long-term business risks and complementary to our QUALITY philosophy.

We maintain the reputation established by the Group since its inception in 1926, as a recognised leader in investment management. Our objective is to understand the circumstances and aspirations of each of our clients with the aim of sharing the commitment towards achieving their unique goals.


1ESG and financial performance: Aggregated evidence from more than 2000 empirical studies, Gunnar Friede, Timo Busch & Alexander Bassen 2015 Journal of Sustainable Finance & Investment, 5:4, 210-233, DOI: 10.1080/20430795.2015.1118917

2From The Stockholder To The Stakeholder - How Sustainability Can Drive Financial Outperformance, Michael Viehs, Gordon Clark, Andreas Feiner, 2014/09/01, SSRN Electronic Journal. 10.2139/ssrn.2508281

3The Price of Sin: The Effects of Social Norms on Markets. Harrison Hong, Marcin Kacpercyzk, March 2007. Electronic copy available from


5Corporate Sustainability: First Evidence on Materiality. Mozaffar Kahn, George Serafeim and Aaron Yoon 2015. Electronic copy available from

6Assessing Risk Through Environmental, Social and Governance Exposures. Jess Dunn, Shaun Fitzgibbons and Lukasz Pomorski. Journal of Investment Management, Vol 16, No.1 (2018), pp. 4-17

7 as at 30th September 2019


9Tracking error Is the divergence between the price behavior of a position or a portfolio and the price behavior of a benchmark. 

10Corporate Goodness and Shareholder Wealth, Philipp Kruger. Journal of Financial Economics, 2015, vol.115, issue 2, 304-329 Electronic copy available from

11QUALITY refers to DGFM’s in house definition which is explained in Davy Asset Management - “Quality Matters” White Paper – Chantal Brennan, Paraic Ryan, Hannah Cooney: 2016 (available on request). Note that this philosophy relates to that as developed within Davy Asset Management prior to its merger on 29th November 2019 with another entity of the Davy Group, Davy Investment Funds Services Ltd. It now reflects the QUALITY philosophy within the merged entity, Davy Global Fund Management.

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