Ignoring ESG investing could be an expensive mistake

Be it organic vegetables, fair-trade tea or cruelty-free cosmetics, ethically sourced products have a reputation for coming with high price-tags. And there's a widespread assumption that the same principle must apply to investments. After all, companies who adhere to higher standards in relation to the environment and the treatment of their workforce might logically forego some profit potential compared to less scrupulous rivals. Also, certain industries that typically score lowly for their ethical credentials such as tobacco and arms makers have delivered strong returns to shareholders over time.

So, does taking the moral high ground when investing come at a cost of lost performance?

At Citi Investment Management, we believe that the answer is no. In 2018, we reviewed an analysis of the results of more than two thousand academic studies carried out since the early 1970s. More than half of the studies found a positive relationship between companies that score well when evaluated based on factors that align with environmental, social and governance (ESG) principles and corporate financial performance.^[1] In other words, companies with higher ESG standards often had better financial metrics, such as profitability.

We also researched investment managers who focused on companies with favorable ESG credentials since 2010. We found that such managers achieved comparable returns to traditional managers, but with lower risk.

These positive relationships are no coincidence, in our view. We believe that companies that recognize and act their responsibility to serve the greater good alongside their shareholders interests may be at an advantage. Such companies may achieve greater respect and loyalty from their customers. They may also find it easier to attract and retain talented employees from diverse backgrounds. As a result, these companies may be able to generate stronger profits, higher returns on capital, and more robust security price performance.

Of course, the past isn't necessarily a guide to the future. However, we believe that the positive relationship between ESG credentials and financial and investment performance may well persist. Changing social attitudes are likely to drive this. Investors are proving increasingly passionate about many issues such as climate change, public health, fair trade, equality of opportunity, and working conditions. This is particularly notable amongst younger generations and female investors.

As these generations influence as consumers, managers, investors, and voters increases with the passage of time, companies will need to continue adapting their behavior. Firms with high and improving ESG standards may be rewarded by consumers and financial markets alike. By contrast, businesses that are seen as having negative impacts are likely to suffer. For example, firms that damage the environment or human health will likely face increasingly costly regulation, penalties, and lost business.

Given our outlook, Citi Investment Management is making strides to formally incorporate ESG into our portfolio construction process. As popular opinion continues to shape government policy and the business environment, the positive relationship between ESG credentials and performance could strengthen further. The highest costs, therefore, could be paid by those investors who fail to take account of this.