Do eth­i­cal busi­nesses make for good in­vest­ments?

The Pak Banker - - OPINION - Sachin P. Mam­patta

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.

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