12 July 2019

Doing Well While Doing Good—Can ESG Limit Downside Risk?

By Bonnie M. Wongtrakool

The effect of environmental, social and governance (ESG) factors on investment returns is a perennial, albeit evolving, topic in the investment community. In a survey conducted by Aon1 in 2018, 38% of global institutional investors not using ESG cited uncertainty around ESG performance as a driving concern. Yet over the past 12 months, interest in ESG has markedly accelerated, and it is worth noting that investors are now asking whether ESG can serve as a risk mitigator at this point in the credit cycle.

Numerous studies on equities illustrate how using ESG in portfolio construction can reduce downside risk and volatility. With historical fixed-income ESG data reaching critical mass, evidence is emerging that these benefits apply to bonds as well. ESG bond funds have historically performed in line with or slightly better than non-ESG bond funds during normal conditions, and have outperformed substantially during periods of market stress. More specifically, a high ESG quality corporate bond portfolio would have outperformed a low ESG quality corporate bond portfolio by 3.6% during the 2014-2016 oil and commodities downturn, according to analysis published by Bloomberg in August 2018. Notably, a portfolio comprised of energy issuers with best-in-class environmental practices would have outperformed one comprised of worst-in-class issuers by 6.5%. Studies have similarly found a positive relationship between performance and ESG within the sovereign sector.

In our own experience at Western Asset, using an ESG integration approach has helped us to avoid underperforming issuers. Our research analysts evaluate material environmental, social and governance factors in conjunction with traditional metrics, seeking to identify investment opportunities where market pricing diverges from fundamental value. As part of this comprehensive research process, our analysts also engage with issuer management to more deeply examine areas of interest and concern. Direct conversations with issuers are a particularly powerful tool with respect to assessing governance, which our analysts treat as the “weakest link.” In a number of cases, governance concerns have led our research team to recommend passing on or divesting from deals, under the principle that poor governance negates the effect from positive environmental and social factors.

ESG investing is already experiencing robust growth due to regulatory support, institutional commitment, climate concerns and generational trends. Half of the investors surveyed by Aon last year stated they would initiate or increase ESG investing if they saw positive research on this front. Accordingly, we believe risk/return studies will provide an additional tailwind to the ESG market over the coming years.

12018 Global Perspectives on Responsible Investing, Aon: