Outperformance by ESG indices versus parents stems from “better financial performance and/or higher investor valuation of constituents”.
ESG indices do not necessarily sacrifice financial returns while pursuing ethical investment, says a new study published by the Hong Kong Exchanges and Clearing (HKEx).
The study, which examined 23 pairs of blue-chip equity indices and their corresponding ESG indices, found that across regional, global, and home country markets, ESG indices tended to have similar, if not better risk-return performances, outperforming on average their parent indices in terms of daily returns, volatility and period returns over the short- and medium-term investment horizons used within the research.
The HKEx study noted that ESG investment strategies had become increasingly popular with investors, driven by multilateral initiatives such as the Paris Agreement and the United Nations Sustainable Development Goals, “as well as the growing market demand for sustainable development”.
Rather than consistent factors explaining higher returns, the specific characteristics of individual ESG indices may contribute to their outperformance relative to parent indices. Several ESG indices showcased outperformance at times within the study period, with a number displaying significant statistical differences against their parent indices, in terms of volatility of returns.
More than half of the ESG indices outperformed their parent indices in terms of period returns for short- and medium-term investment horizons (three-month, six-month, one-year, three-year and five-year holding periods). When looking into the performance of individual indices in each index category, the study found that more than half of the home country ESG indices under-performed parent indices in six-month and three-year holding periods. But the differences between the period returns of the ESG indices and their corresponding parent indices for all holding periods, were not found to be statistically significant.
ESG indices are usually constructed from parent indices, with incorporation of ESG investment styles and requirements. As ESG indices include screening for companies with clear negative ESG impact, and include companies demonstrating positive ESG impact, the risk-return performances of ESG indices may differ from those of their parent indices.
The study concluded that the potentially better returns of ESG indices against those of their parent indices may be closely tied to “the better corporate financial performance and/or the higher investor valuation of constituents with better ESG performance, or investors’ preferences for specific ESG investment strategies”.
Sometimes compared unfavourably to active ESG investment strategies, the HKEx study nevertheless demonstrated ESG indices can offer opportunity for similar, if not better, financial returns than parent indices. The study in particular highlighted the MSCI KLD 400 Social Index, which has outperformed MSCI USA Investable Market Index in its annual returns for seven of the past nine years.
The study period covers 10 years spanning from 1 July 2010 to 30 June 2020. Due to different launch dates, only 12 out of 23 index pairs were observed across the entire period.