Why sustainable investing does not mean lower returns

One of the enduring myths about sustainable investing is that doing good comes at a price. You can have a clean conscience or investment gains, but not both at the same time. At Fidelity, we believe this is simply not the case.

Is sustainable investing profitable?

To test this hypothesis, Fidelity International performed a comparison across all 2,659 companies covered by Fidelity’s equity analysts and 1,450 in our fixed income universe.

It was a simple test. We ranked the companies we follow on the basis of their ESG merits, so it was an easy enough job to see whether stock market performance was correlated to our A-E rating system.

We conducted our analysis in October 2020 using data for the first nine months of the year and we were delighted, although not altogether surprised, to see that the most highly-rated companies performed best, followed by the second most highly-rated group and so on, all the way down to the worst-rated and worst-performing category.

The correlation was linear. Each group beat the one below it, from A down to E.

Does sustainable investing lead to lower returns?

No. The top-rated A and B groups actually beat the lowest rated D and E categories in each of the nine months except one, and even that exception proved rather than undermined our central claim.

That’s because the outlier was April, the month in which markets bounced back most strongly from the heavy falls experienced in February and March. Very often, when a market recovers from a big sell-off, it is the lowest-quality shares which bounce fastest because they have been hardest hit in the downturn.

So, all nine months in the study confirmed the apparent link between strong environmental, social and governance scores and good management. Sustainability does seem to be a kind of proxy for quality.

This correlation actually poses a tricky question. It suggests that maybe the real reason for the outperformance is not a company’s ESG credentials but simply its quality. If that is the case, then we might simply be confusing correlation with causation.

Do ESG investments outperform?

To settle that question, we sliced and diced our universe of companies another way. This time we collected the companies in five buckets on the basis of their return on equity (a shorthand for quality). Then, within each of these groups, we did the same ESG ranking. We found, to our relief, that whichever quality bucket you chose, the link between ESG rating and stock market performance held true.

One other thing Fidelity analysts do when looking at companies is to decide whether their ESG qualities are improving, staying the same or deteriorating. We wondered whether this might be a predictor of performance too. And, sure enough, we found that companies with an improving ESG profile outperformed stable ones which in turn outperformed those where attention to environmental, social and governance factors is getting worse.

By the way, we found a similar effect when we looked at bond performance and ESG ratings. The correlation was not quite as strong as it is with stocks, but the evidence is still compelling.

Bottom line

This analysis is powerful because it appears to have worked in both down and up markets in 2020. Regardless of whether investors find themselves in a bull or a bear market, focusing on companies that take sustainability seriously can be rewarding. The market seems to discriminate between companies based on their approach to ESG.

This is not just an argument for investing in funds with an explicit sustainability focus. It is also an argument for backing investment firms with a track record of integrating ESG factors into their analytical approach.

In the extraordinary market conditions of 2020, you might have thought that sustainability was a luxury you could do without, putting environmental concerns, stakeholder welfare and corporate governance on the back burner to focus instead on maximizing profits, whatever the cost. In fact, the reverse is the case. Doing the right thing makes good investment sense too.

Want to learn more about sustainable funds? Check out the following funds from Fidelity: