Incorporating ESG Momentum Into an Investment Strategy

Drew Johnson, Client Solutions Associate also contributed to this article. 

It is no secret that with the increased attention surrounding sustainable investing, firms globally are revising their investment criteria to make considerations for environmental, social, and governance factors. While there is no standardized way to interpret or measure the three pillars of ESG, proprietary data sets are beginning to allow analysts and managers a way of explaining performance through a non-traditional lens. Aside from the positive public perception of ESG investing, a growing body of academic research suggests that ESG leaders outperform their peers.  

In addition to looking at existing ESG ratings, investors seeking positive alpha generation within an ESG framework can consider changes in ESG ratings. This idea, known as ESG momentum, has been shown in various studies to outperform the general markets, as well as markets with an ESG tilt. UBS recently published research supporting this in a report titled, Education Primer: ESG Improvers equities. The report highlights how ESG momentum can be implemented into a traditional investment approach. UBS argues that companies investing to improve ESG ratings (for example investing in more energy efficient buildings) will lead to improved financials (lower energy costs going forward).

Testing ESG Momentum

In this article, we test this approach by fractiling the S&P 500 into 10 groups based on five-year ESG momentum. We looked to see both the performance of these securities but also the underlying fundamentals.   

Sustainalytics is the concentrated data set we used for our analysis. As of December 31, 2014, they group offered coverage on 98% of the constituents of this index. One of the pivotal metrics Sustainalytics offers is an ESG Indicators Score, which is representative of the top-level rating for a company’s exposure to ESG factors and management's ability to mitigate associated risks. Regardless of the vendor, isolating a top level ESG score is subject to a degree of subjectivity. This provided another reason to study the momentum of this score or ultimate growth in ESG for the period.

When interpreting a five-year percentage growth period through May 2019, the top decile of ESG growth within the S&P 500 returns figures that surely grab your attention. Most notable is the significant outperformance relative to the index aggregate. Over this period, the top decile of constituents returned a shocking 4,337 basis point outperformance, returning 101.67% total return relative to the 58.30% total return of the S&P 500. To account for sampling error in our analysis, we tested this fractiled analysis with the Russell 1000 and MSCI World Index and returned a 4216 and 1145 basis point outperformance respectively.  

With these impressive top-line returns, we can examine whether this performance is exclusively related to a shift in public perception, or whether the true underlying business was also improving due to investments in sustainability. Focusing on growth in ESG over the past five years to define our fractiles, we can further outline if a companies’ investment in itself improved the underlying financials that they are reporting. 

Within this framework, the top decile of ESG momentum companies as compared to the index aggregate proved to show a noticeably higher weighted average in numerous fundamental statistics including: 3Y sales growth (14.1% vs 9.5%), operating margin (32.45% vs 22.37%), return on equity (29.86% vs 22.54%), and return on assets (13.32% vs 9.37%). 

One of the biggest concerns regarding sustainable investing is the perception that a corporation’s focus will retract from underlying profits. Instead, companies that were consistently improving their ESG scores, saw margins that were significantly higher than the benchmark. These higher margins consequently translate to higher returns on equity and assets, further demonstrating how firms can better utilize their capital, yielding higher returns. There has long been a stereotype that businesses concerned with ESG operate at a disadvantage when trying to win new business. These historical growth numbers suggest the opposite. 

Besides the financials, another noticeable characteristic of the companies in the top decile was their beta. With a beta of 1.30 this top decile outlines an evident risk-return trade off. While this profitability may suggest a strong reason to invest, the volatility attached to this subset of securities should be full understood. The last decade has seen the markets soar to new heights and the five years used in this study were particularly good for stocks, with the average return of the index being 58.30%.  

Taken altogether, ESG improvement is an exciting new factor that can be integrated into the portfolio construction process to better understand the universe of investments. ESG momentum not only shows outperformance, but improvement in the companies’ underlying financials. While there is still further research needed to be done to test ESG momentum during a market downturn, historical data has demonstrated how a concentration on ESG momentum generates positive alpha. In addition, the lack of a universal definition of ESG and significant differences in evaluation, lead to significant differences in portfolio construction of pure ESG leaders. In addition, further research is needed to study the effect changing ESG methodologies has on ESG momentum.

Currently, any changes in methodology by a data provider could cause false momentum signals. To combat this, managers should consider using multiple data providers and blending the momentum score. This will help to reduce variation due to changing methodology and give a more complete picture of ESG momentum. To combat the higher beta of the top ESG fractile, managers should also conduct individual security research to manage the risk of the firms they own.