Intuitive arguments used by detractors of sustainable investing suffer from major pitfalls
Even in the face of the growing appetite for ESG investing and the rising number of fund strategies that incorporate the approach, detractors continue to question its merits. In particular, two critiques are often advanced as true based on intuition or perception – even though they can be debunked based on evidence.
In a new blog post published by the CFA Institute, Joachin Klement, CFA, questioned the assertion that compared to conventional portfolio management strategies, those with ESG overlays must underperform as they entail “optimization with additional constraints” – that is, they exclude companies that are not up to par in terms of ESG scores.
But as Klement pointed out, serious ESG investors have already moved on from exclusionary approaches. “The next iteration of ESG was the best-in-class approach,” he said. “ESG portfolios invested in all sectors but only in the companies with the lowest ESG risk in each sector.”
While the approach comes with certain challenges, he said it does slam the door on the argument that ESG investing and conventional investing cannot possibly have the same risk-return trade-offs. To illustrate, he pointed to the MSCI World Index and the MSCI World ESG Index, which have virtually the same performance, thought the ESG benchmark has achieved an annualized return of 5.35% since its 2007 inception compared to 5.32% for its conventional counterpart.
“The same exercise with regional and country indices yields the same results,” Klement said. “The performance of ESG indices has more or less mirrored that of conventional indices over the last decade or more.”
And while arguing that ESG investing must underperform its orthodox counterpart because of the additional constraints might make sense, he noted that it’s a purely theoretical argument. While it might be true in an ideal world, the way it plays out in reality is likely to be vastly different.
“Modern portfolio theory assumes that we can forecast future returns, volatilities, and correlations between assets with extreme precision,” Klement said. “But in reality, every forecast has estimation errors … In the end, the uncertainties around our forecasts are so much bigger than any constraints that modern ESG investing may put on our portfolios.”
