Is ESG (environmental, social and governance) everywhere these days? Certainly, interest in sustainable investing is growing globally, driven by investors trying to increase risk-adjusted returns (“doing well”) and support sustainable outcomes (“doing good”).

But some investors still worry that focusing on ESG could hamper financial returns. The JP Morgan analysis finds no meaningful trade-off between doing good and doing well when investing in public markets.

Given that environmental, social and governance (ESG) investing does not come at a cost in terms of performance, it can be seen as a “free option” to align portfolios with investors’ values, as well as to prepare portfolios for the impacts of potentially tighter environmental or social regulation.

An investor choosing to invest in a region’s equity or bond market will not face a total return or volatility penalty by incorporating ESG factors. As they assess the data, a sector-neutral equity portfolio is not hindered, relative to its benchmark, by a skew toward ESG leaders (defined as companies that perform well in J.P. Morgan Asset Management’s ESG scoring framework).

Asset class selection, ESG optimization

Although research shows that incorporating ESG considerations need not come at a financial cost, it could do so if investors reduce their opportunity set to assets whose ESG characteristics are easy to score and for which scores are readily available. For example, investors that want their portfolios to have a minimum ESG score might be tempted to avoid certain markets or regions, such as the emerging markets. A better portfolio solution is one that optimizes first on region and then within a region on ESG score.

Similarly, investors should not be discouraged from investing in private markets just because ESG data can sometimes be harder to obtain. Indeed, turning away from private markets can be a real loss because these markets are increasingly providing portfolios with solutions for attaining income, diversification and alpha.

Looking at portfolio construction more broadly, investors should consider asset classes based on a desired risk-return outcome and then optimize for ESG characteristics within each asset class. Essentially, that means tilting the portfolio toward ESG leaders or “improvers” within each asset class.

“To optimize returns, investors should optimize ESG leaders or “improvers” within an asset class, rather than choose asset classes that have higher average scores.”

Private market potential

The opportunity set should be as broad as possible, including private as well as public markets. It can be challenging to identify privately held ESG leaders—there’s no doubt about it. ESG information can be notably less transparent in private markets, requiring more research and investigation.

However, turning away from this arena could be a real loss. That’s because these markets increasingly provide portfolio solutions for attaining income, diversification and alpha. Finally, investment in private markets not only can help achieve return objectives – it’s also likely to be essential for achieving sustainable outcomes as private markets grow in size and importance.

The report – Doing good and doing well: ESG trade-offs in investing – is available here in short version, and in full, here.

Source: J.P Morgan – Caspar Siegert, Karen Ward, Nicolas Aguirre, Philippa Clough, Kerry Craig, Tim Lintern, Patrik Schöwitz, Shivani Sharma

risk-adjusted returns