Do ethical businesses make for good investments?

DO investors who avoid companies with poor environmental, social and governance standards pay a price in terms of returns? To find out, Mint looked at three seldom-tracked versions of popular indices that weigh their constituents on the basis of environmental, social and governance (ESG) standards.

As Chart 1 shows , those that used ESG factors to construct their portfolio have not taken a significant hit on their returns. In fact, their returns are actually higher in two out of the three cases since inception.

While the S&P BSE Carbonex, which weighs its constituents in terms of their climate risk relative to others in the industry, has slightly underperformed its benchmark, the other two have done better over different timeframes. This is not dissimilar to the global experience.

In developed markets, this type of investing is gathering momentum. Asset managers who together manage $1.6 trillion wrote to stock exchanges asking for better sustainability by listed companies in 2011. America's largest pension fund, California Public Employees' Retirement System, (CalPERS), pushed investment managers in 2015 to integrate ESG measures in their investment decisions.

However, it is not exactly clear how much investment in India is being done with an emphasis on such standards. MSCI, which manages one of the indices cited above, says demand is still in a nascent stage although it "anticipate(s) growing demand as pension funds, provident funds, insurance firms and other asset owners in India realize the materiality of ESG issues."

It is important to note here that constructing an index on ethical standards is not necessarily an alpha generating strategy. Rather, it is about following a principle-based investment approach without hurting monetary returns.

A January 2013 Indian Institute of Management (Calcutta) paper authored by assistant professor Arpita Ghosh titled '' noted that factors which result in better sustainabili Corporate Sustainability and Corporate Financial Performance: The Indian Context ty include lower leverage and affiliation to business groups.

"Our findings suggest that the companies which are large in size, have less leverage, are business group affiliated, have higher R&D and advertisement expenses, and are operating in environmentally sensitive industries are likely to be superior in sustainability," noted the working paper.

That said, higher returns-at least in the MSCI ESG index-have come with lower risk.

"…It is interesting to note that MSCI India ESG Index has higher returns, lower Annualized Standard Deviations and lower turnover than its parent index, MSCI India," said Thomas Kuh, Head of ESG indexes at MSCI in an emailed response.

Returns and other ratios for the Greenex and Carbonex, however, show a mixed trend. Leverage is the only factor which is uniformly better for ESG indices in India.

So if it's not better company performance, what allows these indices to give roughly the same or even better returns than their more popular peers?

"Performance attribution shows that about half the performance difference can be attributed to factor exposures and about half to stock specific returns," said MSCI's Kuh.

Factor exposure refers to a specific risk that an investor is exposed to through ownership of a security. Returns are often explained by such risk exposure. For example, an investor who has generated high returns through holding small companies is getting returns relative to the risk borne through this holding. Large mature companies may not provide similar returns.

IIM's Ghosh doesn't agree and says adherence to ESG factors in themselves has provided higher returns.

"…the differentiator in these indices are that the primary factor considered to construct the index are the ESG factors. The performance hence is attributed to those factors and the index basically displays the same," said Ghosh. Whichever you look at it, ethical businesses do seem to make for good investments.