MARKETS & INVESTING
SUSTAINABILITY & PORTFOLIO RETURNS
Karen Ward Chief Market Strategist for EMEA J . P . Morgan Asset Management
Hugh Gimber Global Market Strategist J . P . Morgan Asset Management
How does incorporating information on environmental , social and governance ( ESG ) risks affect the performance of a portfolio ? To find out we investigate past data and discuss its limitations , particularly in predicting future performance . We also consider whether changing consumer preferences and evolving regulatory and policy initiatives to tackle ESG issues might mean that investors who are ahead of the change might be expected to see portfolio benefits .
Historically difficult to test Empirical back-testing to gauge relative performance is fraught with practical difficulties , largely due to the lack of quality historical data on which to score companies . The primary issue with back-testing relates to how to score a company on its E , S and G characteristics . There are external ratings agencies that provide company ‘ scores ’ on these metrics , but this data can be impacted by opaque and subjective scoring methodologies , while coverage of companies isn ’ t always complete , particularly for smaller firms and fixed income issuers . Also , the further we go back in time , the more likely it is that the scoring data does not adequately capture real-time ESG challenges . The data may not have been available or disclosed at the time and , more importantly , the data that is actually relevant to asset pricing has likely changed over time . Twenty years ago , governance may have been the most relevant non-financial metric for assessing the sustainability of corporate performance . Today , environmental issues are in sharper focus , as are social issues such as workforce diversity .
Market leadership and short-term sustainable returns Rather than tilting a portfolio based on ESG scores across all sectors , some investors may prefer to focus on risk mitigation by excluding certain industries or sectors to reflect their sustainability preferences . At certain points in the economic cycle , excluding specific companies – such as gambling , tobacco , nuclear power , weapons , alcohol and energy firms – for sustainability reasons can have meaningful implications for relative performance . Most obviously , excluding traditional energy companies from a portfolio will likely lead to outperformance when oil prices are falling , but potential underperformance when oil and other energy prices are rising . If energy accounts for a large proportion of a benchmark , the relative impact is even greater . Looking at the impact of excluding energy in the UK ( where the sector currently makes up over 13 % of MSCI UK ) vs the US ( where energy comprises 4 % of the S & P 500 ) during the recent energy price rollercoaster demonstrates this point . EXCLUDING THE ENERGY SECTOR CAN MATERIALLY IMPACT RETURNS
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