If corporations were high school students, should SRI investors only focus their attention on the most well-behaved ones, or do the slackers who look to be turning a corner deserve some attention, too? I asked this question at a recent roundtable discussion that focused on local and sustainable investing strategies. The answer I received has both directional and financial consequences.
Nearly two thirds of our group indicated that they were most interested in directing investment towards high-performing corporations relative to their industry peers on material sustainability measurements.
Alternatively, a similar poll that I recently conduced via my Twitter account identified that 56% preferred focusing on the improved slackers.
As you can imagine, the answer to this question informs one’s portfolio construction.
A best-in-class “well behaved” focus matches well with many current sustainable investing strategies offered through domestic and international funds available on the market. For example, the FlexShares STOXX Global ESG Impact Index Fund (ESGG) focuses investment on top-half scoring corporations from around the world and charges a very reasonable management fee. As I’ve noted before—and will likely continue until I’m thoroughly convinced of broad acceptance—best-in-class sustainable investment strategies perform just as well as traditional strategies that ignore stakeholder impact risk.
But what about those corporations currently working to improve their ESG (Environmental, Social, Governance) scores? There’s a hint of evidence that investing in the improved slackers may even outperform a standard ESG index. What I call improved slackers is an ESG momentum measurement offering evidence of improvement in corporate social responsibility performance. These are companies striving to improve their ESG scores over time.
Two different studies (here and here) both came to the conclusion that companies who have improved their ESG scores over the last 12 months outperform a best-in-class ESG index. I argue that we only have a hint of evidence because financial statisticians require a minimum of 25 years of return data before you can identify the difference between a robust return-enhancing factor and a short-term trend. Eugene Fama pushes this minimum data requirement to 65 years and yet we only have 15 years of ESG data to test at this point.
An ethics professor from our regional business school here in Virginia recently made a convincing case that changes in culture take much longer than a year. A 12-month improvement is certainly no significant trend. Plus, one could argue that improved slackers will just revert to their old ways as quickly as the winds change direction.
Yet, it seems a bit harsh to silently question the genuineness of recent improvements until they’ve been tested over many years. What will come of the corporate zeal for sustainability if the message from investors is that corporations are on their own until they’ve become standard-setting masters? Fewer corporations will risk pursuing any other bottom line than a financial one. The best sustainable investing strategy may be one that acknowledges the efforts of both groups.