Research: Our Ethical Portfolios Outperform

An article by Jonathan Ramsay of InvestSense Asset Consultants , which explains how and why the backtesting of our Ethical SMA share portfolios shows long term outperformance. This White Paper was released in October 2015, as part of Ethical Investment Week (#NEIW15). [Note: InvestSense are no longer associated with the portfolios].

At the end of 2014 we were asked by JustInvest Financial Planning to help construct two ethically biased portfolios. The portfolio with the strongest bias was to become the Dark Green Opportunities Portfolio. It has no direct or even indirect exposure to Fossil Fuels, Uranium and Defence Industries. It also has no direct exposure to Extractive Industries, Gaming, Alcohol or Tobacco stocks. The Light Green version relaxes the constraints such that it only needs to avoid direct exposure to those sectors. The information needed to determine these exposures was provided by CAER, the provider of environmental, social, governance (ESG) and ethical ratings. We also screened the universe for overall ESG performance on the basis that an ethically sustainable portfolio should also be biased towards companies that rank well on ESG criteria. However, these constraints can lead to significant portfolio biases towards, for instance, particular sectors or size of company. This is especially true in Australia. Therefore we spent some time working on the composition of the portfolios in order to make sure that these unintended biases didn’t dominate their risk profile and behaviour. We also firmly believe that in the world of investments nothing should be done ‘at any price’. Therefore the last element in the process was to apply a valuation overlay to make sure we weren’t overpaying for the ‘quality’ bias that can be attached to some of the best and most sustainably run companies. Equally we wanted to make sure that we had excluded some of the riskiest stocks even if they appeared cheap.

As we looked at these attributes we noticed that over at least two decades we found in these portfolios consistently higher rates of Return on Equity, or using another metric, Cash Flow Return on Investment (as defined by Credit Suisse and their HOLT valuation model). We found also that the stronger ethical bias led to higher CFROI. CFROI is a measure of wealth creation and the extent to which it exceeds the firm’s cost of capital (how much it costs to raise equity or borrow debt) tells us whether the companies in the portfolio, when viewed as one diversified conglomerate, are effective in building shareholder wealth. The graphs below compare CFROI levels (blue bars) with the aggregate cost of capital for the portfolio (green line). Note that these margins are much higher than for the Australian market which has in turn enjoyed higher levels than elsewhere in the world.

Chart 1 (a) Light Green Opportunities Portfolio 

Chart 1 (b) Dark Green Opportunities Portfolio

(Source: Credit Suisse HOLT)

Of course you can still lose money by paying too much for highly efficient companies, but we began to wonder whether this ‘quality’ bias had in fact been fully discounted by the market over time or whether investors in more sustainable, well governed companies had in fact done better than the market. We therefore asked CAER for their ratings going back 15 years and constructed a portfolio that excluded all companies that scored less than 3 out 5 on any of the of Environmental, Social or Governance Criteria. We then equally weighted the portfolio and rebalanced at every year end and compared that portfolio with the performance of the overall market as well as the index of smaller companies (the equally weighted portfolio has a significant bias to small caps). We also looked at a portfolio of stocks that scored 2 or less on at least one of the ESG criteria. See Chart 2 following (Source: InvestSense, CAER,  Bloomberg):

Clearly the performance of the ESG portfolio has been far superior especially in the run up to 2007 and then again over the last 5 years. As an equal weighted portfolio there are clearly some large biases that might account for these differences, the biggest being the overweighting to small cap companies (with 75% of the portfolio in companies in the S&P/ASX Small Companies index it is essentially a small companies portfolio). However, this does not explain the latter period of significant outperformance. Indeed looking at the attribution of returns at a sector level, after taking size into account, it appears that this is not due to sector biases either. In fact the largest sector position is an underweight to Financials, which have performed well.  In fact if we dig a little deeper this recent outperformance is despite the very negative influences of size and sector biases. As we dissect the portfolio further we see that the sources of extra outperformance are quite evenly spread across many sectors and across the market capitalisation spectrum.  In fact if this was an active fund manager you would say that the stock picking ‘hit rate’ at a stock level (positive contribution after allowing for sector performance was a quite remarkable 66% (over the entire period). Clearly something interesting is going on here.

Apples vs apples

We also created a more comparable equally weighted benchmark and the results are similar. Interestingly the ESG Focus Portfolio now exhibits a reasonable bias in favour of large companies and it is this that accounts for a large part of the outperformance, providing some anecdotal evidence that larger companies tend to rate higher on ESG and that that has had a positive impact on performance:

(Source: InvestSense, CAER,  Bloomberg)

It is also interesting to note that even when the ESG portfolio underperformed it tended to exhibit less volatility (it lagged when the market rose but didn’t fall as much when it fell). Indeed the following table demonstrates that over the last ten years the risk adjusted return was even more impressive. Does this suggest that ESG factors capture some underlying operational risks as well as risk factors that are perceived by the market? Do investors retreat to companies that are seen as more sustainable and well governed during times of uncertainty?

(Source: InvestSense, CAER,  Bloomberg)

The purpose of the article is not to provide a robust, cross-sectional review of what drives the relative performance of portfolios with an ESG focus. Rather it is to ask questions such as those and examine whether there might be some positive attributes associated with well-run companies (by ESG metrics at least) and most importantly whether they tend to be adequately discounted by other market participants. We can, tentatively, conclude that there appears to be some evidence that this has been the case in the past and we are looking forward to exploring these issues more fully with CAER. For now we can, at the very least, say that ethical investors have not been disadvantaged by their conscience.

As for our role as advisors on the construction of the Dark Green and Light Green Opportunity portfolios with JustInvest, we think there is another more pressing issue that faces ‘Green’ investors. Typically when a group of stocks do very well they become expensive in the process which can lead to underperformance down the track. On the other hand the current and future environment might be one where sustainable companies find it easier to grow their earnings faster than the market and they could still be cheap. In a similar vein it seems likely that recent outperformance is related to the subtle and only partly visible relationship between ‘quality’ stocks (such as those with dependable earnings and low leverage) and stocks that are good quality from an ESG perspective. Such quality stocks have rallied especially strongly in the post-GFC environment and many of them do appear to be getting quite expensive. These are both reasons why we believe that with ethical investing, as with all investing, care must be taken not to overpay. This is why there is a valuation component in the process we have put together for JustInvest and it may be more necessary for ethical investing than it has been in the past.

Note: Past performance is not an indicator of future performance

Our Dark Green portfolio is now known as the Ethical Investment Large Cap portfolio.

For more information about the Ethical Investment Mid-Cap portfolio, please click here

About CAER

Corporate Monitor is a trading name of CAER – Corporate Analysis. Enhanced Responsibility. CAER is an independent research organisation. We assist investors seeking to apply environmental, social and governance criteria to their Australian and international investments. CAER was established in 2000, and with our European partners Vigeo – EIRIS we are able to provide consistent sustainability data on over 10,000 of the world’s leading companies and issuers. Our mission is to empower responsible investors with independent assessments of companies and advice on integrating them with investment decisions. We have over 15 years’ experience of promoting responsible investment and helping consumers, charities and advisers invest responsibly.  For more information on CAER:  or Corporate Monitor: