Comment

There is no trade-off between doing good and beating the market

It now looks irrefutable that environmental and social factors are a clear guide to company quality and future investment returns

A green pound with leaves (illustration)
There is a clear link between broader sustainability and investment performance

When MPs vote on a proposed tightening of climate change disclosure by pension schemes on Monday, they will not be deciding whether the measures are a good idea. Rather, they will be asking whether they go far enough.

It is a sign of how far the debate has shifted that both sides of the House are now principally concerned with demonstrating how violently they can agree with each other.

Perhaps it’s churlish to call out this virtue-signalling. As the US prepares to sign up once more to the Paris Climate Agreement, maybe we should just be thankful that over here, there is bipartisan acceptance of the need to do something and get on with it.

A Labour amendment to the pension schemes bill will require workplace pension plans to become carbon neutral by 2050 or sooner. That may not seem unduly stretching, but it is a significant strengthening of the Government’s proposed measures in the bill, which will make it mandatory for company pensions to manage the effects of climate change as a financial risk and to report on how they are achieving that.

Labour’s intervention follows the Chancellor Rishi Sunak’s announcement last week that climate disclosures should be obligatory across a large swathe of the economy, including large companies (public and private), banks, insurers, asset managers and pension funds. Meanwhile, next year should see the issue of Britain’s first green gilt to raise money for carbon-reduction projects.

With almost everyone apparently singing from the same hymn sheet, it was interesting to read the trade body for workplace pensions, the Pensions and Lifetime Savings Association, suggesting that the Labour amendment was unnecessary because pension schemes were already investing responsibly. It furthermore suggested the proposals would "break the principle that trustees should apply their fiduciary duties, and their responsibility to invest in their members’ best interests".

That’s interesting, because on the basis of our latest research into the link between broader sustainability (not just climate) and investment performance, it now looks irrefutable that environmental, social and governance factors are a clear guide to company quality and, by extension, future investment returns.

We concluded long ago that there is no inherent trade-off between doing good and beating the market. The latest numbers confirm this to be the case.

We last looked at the link between sustainability and investment performance in the spring, noting that companies with high scores on our in-house A-E rating system outperformed their peers as the market fell in February and March. This supported our hypothesis that a focus on environmental, social and governance factors is a kind of proxy for good management generally that will get rewarded by the stock market.

To be fair, it was a short period of time over which to draw meaningful conclusions. So we ran the numbers again over the first nine months of 2020, on the grounds that this period of whipsawing markets (a big decline followed by an equally impressive rally), massive policy interventions and uniquely challenging economic circumstances might tell us something more significant.

The period from January to September this year has broken many records. The 16 sessions it took to fall 20pc represented the quickest bear market in US history. The recovery in the MSCI All Country World Index to the same level at which it started the year has also outpaced any equivalent rally.

To see the link between sustainability and performance during this unique market round-trip, we analysed data from the 2,659 companies we assess in this way. Grouping them on the basis of their sustainability rating, we were pleased, but not unduly surprised, to see that A-rated companies beat the index and that each group outperformed the one beneath it in the rating hierarchy.

One of the more interesting findings of our research was the fact that the outperformance of highly rated stocks was not consistent through the whole rollercoaster ride of markets this year. Shares with a low sustainability rating significantly outpaced their worthier peers during the month of April when markets snapped back most aggressively.

Again, this is not wholly surprising. A feature of market bottoms is that the initial relief rally often sees outperformance by unfavoured, cheap stocks – a so-called dash for trash.

We saw something similar last week, when optimism about a potential Covid vaccine led to a spectacular rotation from reliable growth companies to the beaten-up cyclicals that have suffered most in share price terms during the pandemic. High quality companies tend to be less volatile than the market as a whole, falling less on the way down and rising less as the index recovers.

The apparent correlation between sustainability and quality does, of course, beg the question of whether our analysis might be drawing a false conclusion – maybe the more sustainable companies are just better and their outperformance reflects this and not their ESG credentials at all.

It’s a fair challenge, but wrong. To test this, we ranked all the companies by return on equity and then re-ran the analysis within five return "buckets". The same effect was seen each time regardless of quality, higher sustainability results in better performance.

One final finding suggests that the Government and Labour are right to be pushing companies to a greener future. As well as rating companies on environmental, social and governance factors, we also note whether their performance in these areas is improving, deteriorating or stable.

It is gratifying to note that the small minority of companies that are scoring less well over time on sustainability significantly underperformed those that are at least maintaining their rating over time. Pension scheme trustees can rest assured that focusing on sustainability in no way contradicts their fiduciary responsibility to act in their members’ interests.

Tom Stevenson is an investment director at Fidelity International and the views are his own.

He tweets at @tomstevenson63