Reducing risk by investing responsibly

Responsible asset allocation helps investors to look beyond financial metrics and reduce risks associated with a company’s environmental record, its management and its attitude towards its employees and society.

For example, an analysis of a company’s steps to reduce its impact on the environment and mitigate climate change can help investors to reduce the risk posed by global warming. Choosing a company with diverse board which cares about good governance will reduce the hazards of poor management. And those with good social practices are less likely to end up in labour disputes or fighting with local communities. A well-managed company is also less likely to have legal disputes.

Mitigating these types of risk is not about providing protection from the volatility of the equity markets but about reducing specific company hazards, such as bad governance or sub-standard labour practice, or avoiding the long-term threat of the world warming.

Stress test

The sharp correction in the first quarter of this year provided a real life assessment of whether stocks with strong environmental, social and governance characteristics are also able to weather unexpected market shocks.

In a recent post, MSCI looked at the relative performance of four standard global ESG indices compared with their its flagship global equity index. All four of these indices outperformed the reference benchmark in the first quarter of this year.

There is an interesting divergence in the performance of these indices with three of those more tightly clustered. The three which performed in similar way are MSCI ACWI ESG Universal, MSCI ACWI ESG Leaders and MSCI ACWI ESG Focus.

That soup of acronyms needs some translation. The ESG Universal tilts towards companies with good ESG scores which are also improving. ESG Leaders has a similar bias but tightly tracks the benchmark. And ESG Focus also leans towards high ESG scoring companies but aims to match the risk and return profile of the global index.

The fourth index is the MSCI ACWI ESG SRI index. It slightly outperformed these other indices. It differs from them by not only tilting towards companies with high ESG scores but also excluding companies with negative environmental and social impacts.

To gain a better understanding into why these indices performed the way they did, MSCI analysed the returns from different sources such as currencies, countries, stock-specific factors and ESG.

During the crisis, the post says: “ESG was the strongest contributor to outperformance, followed by tilts towards lower beta, lower volatility and better quality.” Over the past five years, ESG provided less significant though still relatively high levels of contribution, it adds.

It’s worth considering what could have driven this better performance. That factors such as lower volatility and better quality also contributed suggests companies with high ESG scores are perceived as well run and have better risk management.

This would indicate companies with high ESG scores are not only capable of mitigating stock-specific risk like governance and social policy as well as the long-term dangers of climate change but also provide some protection during periods of market correction.