Understanding How ‘E,’ ‘S’ and ‘G’ Contribute to ESG Performance

As the Department of Labor (DOL) has proposed a regulation that seems to create stricter limits for environmental, social and governance (ESG) investing in retirement plans, the need is greater than ever to be able to explain and document how ESG considerations will contribute to investment goals.

The three factors that make up ESG investing have been sometimes mistaken as synonymous by the broader market, as each category drives responsible change.

However, governance—which covers board structure, board composition and more—has largely outperformed the other factors in the past, research shows. A series of studies presented by MSCI found that governance consistently showed more financial significance in short-term periods compared with the long-term horizon. Additionally, study results found that from 2006 to 2019, governance scores topped in measuring exposure to financial factors including gross profitability, residual capital asset pricing model (CAPM) volatility and systematic volatility.

“If you have a company that is strong on governance or social issues, what we see is that over that next year time frame, the companies that have strong governance do actually perform better based on those types of financial barriers,” explains Linda-Eling Lee, global head of ESG research at MSCI.

Yet, as recent issues in climate change, and a push for more diversity and inclusion efforts, shine a new light on ESG, more companies are focusing their long-term efforts on advancing environmental and social factors. The MSCI data found that while many companies focus on “G” factors for their success in a short-term period, “E” and “S” factors are more likely to thrive in the longer period.

“Some of the social and environmental factors do actually translate into better performance over a longer time frame,” Lee continues. “There’s this time horizon issue where governance is in the mind of investors, and therefore you can see them in these financial goals for a shorter-time frame, whereas these other intangible issues like social or environmental issues do take a longer time to play out.”

Hernando Cortina, head of index strategy at ISS ESG, a subsidiary of Institutional Shareholder Services, says he believes sustainable investing has always been a long-term consideration. “You never invest in ESG because you think it’s going to be a trade that you’ll work with until the next quarter—it’s always an investing approach,” he notes.

As investors lean toward “E” and “S” factors, including carbon emissions, energy efficiency and diversity, many are finding that ESG is largely outperforming other investments, Cortina adds. Research conducted by ISS ESG found that responsible investing factors had significantly outpaced non-ESG indices by 128 to 278 basis points (bps) from the end of 2019 to May 25 and had reported a lower amount of volatility as well, by 50 to 100 basis points.

What we’re doing in this paper is looking at performance, and also looking at how ESG indices compare on key ESG metrics to their benchmarks,” Cortina says. “And we’re trying to bring it to an intuitive level. We’re looking for example at carbon emissions, and how much lower they are than the benchmarks. We’re trying to tell the story of ESG that is of practical use to the investment manager or the investor.”

The pandemic has reinforced the desire for climate change and ESG investing in the past few months, experts say. Matt Seymour, chief executive officer at RiskFirst, previously noted in an interview with PLANSPONSOR that the effects of the coronavirus will change how people look at ESG investments. “The pandemic is really going to emphasize the rationale and need for people to look at ESG investments in an integrated and fundamental way,” he said.

Another MSCI report divided ESG investments into two categories: event and erosion risk. Event risks are mainly focused on the short term, while erosion-specific characteristics focus on the long term, Lee says. “People like to divide it to ‘E,’ ‘S,’ and ‘G,’ but really what we’re talking about are things that can erupt into events, or it could be accidents, litigation, etc.,” she explains. “And then you have things that are more about managing your resources in a more robust and efficient way. Disentangling the two of them is quite important from an investment perspective of what it is you’re trying to maximize in your portfolio.”

The MSCI research suggests highly active portfolio managers may look to mitigate short-term event risks, usually associated with governance factors. Portfolio managers with diversified portfolios with long investment horizons will be more focused on long-term erosion risks, notes the report. “You see this being adopted by many different investors, and they have several different strategies,” Lee adds. “One of the important things is that with ESG, there isn’t a ‘one-size-fits-all approach’ to getting the most out of the signals that you get.”