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March 25, 2011
Definitions May Vary, but Sustainable Investment Can Outperform
    by Robert Kropp

A review of recent academic literature on sustainable investment by Kimberly Gladman of GovernanceMetrics International finds that incorporating environmental, social, and corporate governance factors can improve investment performance.

In a review of recent academic literature on sustainable investment, Kimberly Gladman, Director of Research and Risk Analytics at GovernanceMetrics International (GMI) has identified more than two dozen studies published during the past three years that focus "on the empirical impact of responsible investment strategies on performance." From these studies, Gladman has written a review entitled Ten Things to Know About Responsible Investment & Performance.

Sustainable investment has undergone an evolution over the years, from exclusionary screening from portfolios of companies in industries such as tobacco to a best-in-class approach. The best-in-class approach ranks companies by their environmental, social, and corporate governance (ESG) reporting and performance, and is generally perceived as allowing for greater diversification of an investor's holdings. An example of the best-in-class approach, Gladman writes, occurs when investors "choose electric utilities whose carbon emissions are lower than the industry average, or retailers whose employee benefits are more generous than is typical."

Yet despite the convergence of much of the field upon an investment approach, definitions of sustainable investment continue to vary. Corporate governance advocates, according to Gladman, "Analyze the issuer's relationships with multiple stakeholders who make contributions to its business and are affected by its operations." These stakeholders can include employees, customers, communities, governments, and the environment, as well as investors, Gladman continued.

The importance of good corporate governance was underscored recently in a conversation with Anthony Miller, the Economic Affairs Officer for the Investment and Enterprise Division of the United Nations Conference on Trade and Development (UNCTAD), who told, "We have to remember that without good governance mechanisms, there is no responsible investment."

Nevertheless, in her review of academic studies, Gladman found that many equity managers continue to focus on a small number of ESG issues in their analyses.

While Gladman concluded that the performance of sustainable investment approaches has been roughly equal to that of mainstream methods, she does note that studies of specific ESG factors have revealed a potential for outperformance in several cases. Furthermore, studies have found "that firms defined as leaders in corporate responsibility have lower idiosyncratic risk," and "that companies with better CSR (corporate social responsibility) records…tended to have higher valuations."

In addition, although the impact of ESG issues can vary according to a number of factors, investment analysis that makes use of ESG factors can be better positioned to forecast the long-term performance of a company. Sustainable investors can benefit by factoring in the cost of externalities as well. Citing a 2010 study by Trucost, Gladman reports "that the cost of environmental damage caused by the world’s 3,000 largest public companies amounts to $2.15 trillion annually."

Given the variety of sustainable investment approaches and the current difficulty in pricing externalities, it is not surprising to learn from Gladman that sustainable investment remains a specialized skill. One report, she writes, "Found that (funds) sponsored by management companies specializing in responsible investment significantly outperformed conventional funds. Those run by generalist companies, however, underperformed."


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