Can my investments do well while the companies I invest in do good? This is a question many investors ask as they consider portfolios that assess environmental, social and governance (ESG) factors as part of the investment process.
Many studies have attempted to answer this question and their conclusions have been inconsistent. Some of the research relies on comparing ESG strategy performance to a broad universe of non-ESG strategies. Other studies compare the performance of a basket of companies with favorable sustainability characteristics to the overall market.
We think there’s a better way to frame the question: Focus on a manager’s ESG integration skills by isolating how each pillar of an investment process affects performance over time.
We can measure the impact of ESG integration with an approach reminiscent of the traditional Brinson attribution model. Among other things, this approach can quantify the benefit of being overweight an outperforming sector or underweight an underperforming sector. Using a similar technique, we can measure the contribution or detraction of being overweight companies with higher ESG scores
We calculate the ESG score using external data sources (e.g., MSCI, Sustainalytics*) to compare companies within each sector and industry based on their management of ESG risks and opportunities. Companies with high ESG scores are viewed as ESG leaders while those with low scores are considered laggards.
Figure 1 illustrates ESG attribution results for American Century Investments’ U.S. Sustainable Large Cap Core strategy (80-100 stocks) and the more concentrated U.S. Sustainable Large Cap Core SMA portfolio (40-50 stocks) since the strategies’ inception more than four years ago.
This attribution analysis clearly illustrates the positive ESG effect for these strategies relative to the S&P 500® Index since inception. The green segments represent the allocation effect from an overweight position in companies with above-median ESG scores combined with an underweight in companies with below-median ESG scores. During this period, the market rewarded companies with higher scores, which added value to the portfolio.
ESG is just one of many factors we consider in the investment process as Figure 1 helps demonstrate. The Business Improvement Model Effect measures the impact of investment decisions using our proprietary business improvement score. This score quantifies the fundamental insights our sector specialists consider most important. As shown in Figure 1, an overweight position in companies with higher scores coupled with an underweight in stocks with low scores added value.
The Fundamental/Portfolio Construction Effect also contributed to performance and reflects portfolio decisions that can’t be explained by the ESG or Business Improvement models. This calculation, reflected in the orange segments, is simply the difference between the total excess return over the index and the sum of the ESG and Business Improvement effects. Portfolio construction is critical to managing an integrated ESG portfolio to help ensure that unintended factor exposures— e.g., market capitalization, momentum, volatility or style biases—don’t detract from or overshadow stock-specific decisions.
This exercise shows that each dimension of the investment process has the potential to add value to relative performance. It’s important to note that ESG metrics represent only a portion of the total excess return. We believe a quantitative business improvement model that identifies companies with attractive financial characteristics and the insights of an experienced fundamental investment team are crucial drivers of relative performance.
Returning to the original question: Does ESG investing add value? We believe the answer is yes. The attribution examples illustrated in this paper show that for the large U.S. companies in these portfolios, being an ESG leader based on our scoring methodology was a tailwind. We believe this scenario will continue as investors pay closer attention to the material ESG risks and opportunities companies face relative to their peers.
Past performance is no guarantee of future results. Investment returns will fluctuate and it is possible to lose money.
A strategy or emphasis on environmental, social and governance factors ("ESG") may limit the investment opportunities available to a portfolio. Therefore, the portfolio may underperform or perform differently than other portfolios that do not have an ESG investment focus. A portfolio's ESG investment focus may also result in the portfolio investing in securities or industry sectors that perform differently or maintain a different risk profile than the market generally or compared to underlying holdings that are not screened for ESG standards.
Separately Managed Accounts (SMAs) are investment services provided by American Century Investment Management, Inc. (ACIM) a federally registered investment advisor. SMAs are not available for purchase directly through ACIM. Client portfolios are managed based on investment instructions or advice provided by the client's advisor or program sponsor. Management and performance of individual accounts may differ from those of the model portfolio as a result of advice or instruction by the client's advisor, account size, client-imposed restrictions, different implementation practices, the timing of client investments, market conditions, contributions, withdrawals and other factors.
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