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Despite headwinds, ESG continues to perform

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This is a sponsored article from Federated Hermes.

The latest research from the Global Equities team at Federated Hermes indicates that despite market volatility and the energy crunch, ESG remains an effective performance indicator.

Our previous research confirmed the link between social and governance factors1. In the latest findings, the importance of environmental metrics is evidenced, with the best placed companies performing ahead or in line with peers, while poorly ranked companies tend to significantly underperform.

In our 2020 release, we demonstrated that governance and social factors were a statistically meaningful driver of shareholder returns. The pandemic cemented the importance of social impact, with more socially responsible companies tending to outperform2. Previously, there was weak evidence that environmental factors had similar properties, but the historic relationship was volatile and did not reach the necessary hurdle to be considered significant. That has changed over the last two years, with environmental factors performing on par with social and governance. This confirms that across the environmental, social and governance pillars, the link between ESG and performance is clearly in evidence.

The non-linear shape of ESG

In our inaugural ESG research, published in 2014, we demonstrated a striking aspect of the relationship between governance and shareholder returns, often overlooked in other studies. Namely, the relationship is non-linear. Companies with leading or improving corporate governance scores outperform peers with poor or worsening standards. However rather than performance deriving from the leaders outperforming, the governance premium is largely driven by the underperformance of the laggards. This same pattern exists for the social factor and for the environmental factor. For investors, avoiding the ESG laggards, and those whose standards are slipping, is a crucial way to capture the ESG premium.

Figure 1. Companies with poor ESG practices have historically underperformed over the long term

Average monthly total relative returns of companies in each quintile, based on environmental, social and governance scores, from 31 December 2008 to 30 June 2022. Figures are calculated using constituents of the MSCI World Index, assuming monthly rebalancing.

A worrying exception

The findings are surprisingly consistent across economic sectors, with the notable exceptions of real estate and energy. Within these sectors, the companies with the worst or worsening environmental practices relative to peers have tended to outperform. For the energy sector in particular, this result is concerning, if sadly not surprising. Some investors simply avoid the entire sector in the name of environmental considerations. Does this exclusion by many sustainable investors result in the sector being more influenced by those less concerned by sustainability? If sustainability-focused investors are not acting as stewards of the energy sector, it may be asked, who is?

Figure 2. Notable exceptions: Real estate and energy break the pattern of environmental outperformance

Average monthly dispersion in total returns between companies in the top quintile and lowest quintile, based on environmental scores by sector, from 31 December 2008 to 30 June 2022.

Figure 3. One size does not fit all: the effectiveness of ESG factors by region

Average monthly dispersion in total returns between companies in the top quintile and lowest quintile, based on environmental, social and governance scores by region, from 31 December 2008 to 30 June 2022.

Long-term thinking

Awareness of sustainability keep growing across every sector. Embracing sustainability in general is not just about avoiding risks, it is about finding business opportunities. We stand by the belief that sustainability requires a long-term focus and can deliver the opportunity for long-term results. In the developing environment, we believe businesses with the right longer-term focus will be the ones that thrive.

1 FHL, ‘Reaffirming the link between ESG and performance’ (2020)
2 FHL, ‘ESG Investing: How Covid-19 accelerated the social awakening’ (2020)

Important Information
The value of investments and income from them may go down as well as up, and you may not get back the original amount invested. Any investments overseas may be affected by currency exchange rates. Past performance is not a reliable indicator of future results and targets are not guaranteed.

For professional investors only. This is a marketing communication. The views and opinions contained herein are those of Lewis Grant, director, senior portfolio manager, and may not necessarily represent views expressed or reflected in other communications, strategies or products. The information herein is believed to be reliable, but Federated Hermes does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. This document has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. This document is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Figures, unless otherwise indicated, are sourced from Federated Hermes. This document is not investment research and is available to any investment firm wishing to receive it. The distribution of the information contained in this document in certain jurisdictions may be restricted and, accordingly, persons into whose possession this document comes are required to make themselves aware of and to observe such restrictions.

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Benchmark source: MSCI. The MSCI data is for internal use only and may not be redistributed or used in connection with creating or offering any securities, financial products or indices. Neither MSCI nor any other third party involved in or related to compiling, computing or creating the MSCI data (the “MSCI Parties’) makes any express or implied warranties or representations with respect to such data (or the results to be obtained by the use thereof), and the MSCI Parties hereby expressly disclaim all warranties of originality, accuracy, completeness, merchantability or fitness for a particular purpose with respect to such data. Without limiting any of the foregoing, in no event shall any of the MSCI Parties have any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages.

This is a sponsored article from Federated Hermes.

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