Investors can achieve their long-term objectives while incorporating preferences for sustainability.

Within the field of Responsible Investing (RI), the prevailing investor question is: “Do my preferences for sustainability sacrifice investment returns?” A growing body of evidence points to this not being the case. However, it is dependent on the approach taken by the investor.

An investor who follows an approach that integrates Environmental, Social and Governance (ESG) data into the investment decision process can enhance a portfolio’s risk-return profile. Consideration of this data can enhance risk management and highlight potential opportunities. In addition, it can also result in desirable exposure to high quality companies.

However, an approach with a strong focus on screening can significantly reduce the investment universe, which can increase the level of overall portfolio risk, as diversification becomes more difficult. However, the tail risk associated with RI portfolios can be lower as they are less exposed to extreme ESG outcomes, such as stranded assets.     

The regulatory framework, relating to sustainability of investments, set out by the European Commission, focuses on the consideration of the adverse impacts of investment decisions on sustainability factors. It requires investors to describe how they identify and consider these impacts – which could be argued is more in line with an integration-based approach as opposed to an exclusions-based approach.

Improving underlying risk characteristics

By integrating ESG data into the investment process, investors can better identity the material risks and opportunities a company is exposed to. Material risks are those that would present significant implications for the company and its stakeholders and differ greatly from company to company and sector to sector. For example, a company operating with labour practices inferior to those of its peers is at risk of disruption through labour strikes and poor staff retention. Another example is a company with a high level of carbon emissions is at risk of future litigation which forces them to pay damages for their negative environmental impact.   

An investor can improve the underlying risk characteristics of their portfolio by recognising and investing in the companies that are best identifying and managing their material risks. In turn, this can lead to better risk adjusted returns. However, it is worth stating that assets with the best ESG profiles can be more highly valued than those assets with poorer ESG characteristics. An approach that focuses solely on those companies with the best ESG characteristics may experience lower returns as a result, however this can be offset by including assets with an improving ESG profile.  

Increased Quality factor exposure

At Davy Private Clients we seek to include companies displaying  Quality characteristics  across our offerings. The Quality factor has been demonstrated as having long term outperformance versus the broad market. The companies captured by this factor can be described as having durable business models and sustainable competitive advantages. There is no standard definition of Quality, however, it typically focuses on Return on Equity, Free Cashflow, Earnings Stability, Management Quality and Corporate Governance.

The focus ESG integration gives to Management Quality, particularly regarding identifying and managing material risk and opportunities and more broadly Corporate Governance, coupled with traditional financial analysis typically results in a high-Quality factor exposure. It is our experience that ESG orientated offerings exhibit a higher Quality factor exposure. This is desirable from a risk/return perspective and as a potential source of portfolio outperformance.  

Figure 1 below shows the shows historic performance of MSCI ACWI ESG Indices versus the broader MSCI ACWI Index. The time period considered is May 2013 to 1st May 2025. It should be acknowledged that the time period is relatively short in time series analysis terms; however, it does demonstrate the strong relative performance of MSCI ACWI ESG Indices relative to the broader MSCI ACWI Indices for over a decade. 

Figure 1: Relative Performance of MSCI ACWI & MSCI ACWI ESG Indices (May 2013 – May 2025) **

Source: MSCI ESG Research, “The Drivers of ESG Returns”

Conclusion

An investor embracing an RI investment approach focuses on companies (assets) that minimise their negative impacts on society alongside their individual return objectives. It is not a solely returns focused investment approach. We believe an RI approach that incorporates exclusionary screens and integrates ESG data is superior to a solely exclusionary based approach.

The nature of the RI approach, underweight energy and fossil fuels for example, can lead to short term return deviations from that of the broader market. For instance, the RI approach has lagged the broader market during periods of outperformance for the energy sector or historically when value has outperformed (RI strategies have historically exhibited a value underweight). However, over longer periods the deviations will likely be small as the RI approach’s improved underlying risk characteristics and enhanced Quality exposure are accentuated over a longer term horizon.

** The MSCI ESG Universal Index represents an ESG-weight-tilt approach; MSCI ESG Leaders Index uses a 50% best-in-class sector approach; MSCI SRI Index uses a 25% best-in-class sector approach; and MSCI ESG Focus Index uses an optimised approach designed to maximize ESG exposure. The data shows the actual performance for each index plus back-tested performance for those indexes with less than 10 years of track record. MSCI ACWI ESG Leaders Index has been live since June 6, 2013; MSCI ACWI SRI Index since March 24, 2014; MSCI ACWI ESG Universal Index since Feb. 8, 2017; MSCI ACWI ESG Focus Index since June 25, 2018. Data from May 31, 2013, to May 1, 2025.Performance in USD terms.

Source: MSCI ESG Research