Are firms with better governance good for investors? Trends show this

Indices for companies scoring high on ESG standards have done well in five years but long-term trends are unclear.

The National Stock Exchange announced on Tuesday a new segment where companies will voluntarily take up higher governance standards. NSE Prime allows investors to better identify such companies that get access to quality investors in return.

Companies with higher governance standards appear to have done better in recent years. 'Business Standard' looked at indices focused on companies scoring higher on Environmental, Social and Governance (ESG) standards. Such indices have given around two per cent higher returns compared to their benchmarks on average over the last five years.

The analysis looked at the MSCI India ESG Leaders index and compared it to the MSCI India index. It also looked at S&P BSE 100 ESG index in comparison with the S&P BSE 100. The annual returns of each index was compared to its own benchmark over the last five years. This allowed for checking of outperformance in ten instances (five years each for each of the two ESG indices). ESG indices outperformed in eight out of the ten instances (see chart 1).

The outperformance varied from 0.4 per cent to 7.3 per cent. The best performance in recent years has come during the pandemic year of 2020 for both. The trend is slightly more mixed across the sample in 2021. The year-to-date price returns of the S&P BSE 100 ESG Index was 25.2 per cent compared to 22.8 per cent for the S&P BSE 100 shows a fact-sheet as of December 22, 2021. The MSCI India ESG Leaders Index is up 16.25 per cent compared to 21.7 per cent for MSCI India shows the November 30,2021 fact-sheet. The broad trend shows higher returns for ESG indices despite variations across some periods. The picture on volatility is less clear.

The standard deviation, a measure of relative risk, is lower for the MSCI India ESG Leaders Index compared to its benchmark MSCI India index. It was higher than the benchmark for the S&P BSE 100 ESG index (see chart 2).

There is demand for ESG-based investment opportunities from investors with some estimates putting the assets under management for investors using ESG as a criteria at over $40 trillion. An ESG-based approach seems to cut downside risk according to an analysis in a 2021 note entitled ‘ESG Investing and Climate Transition’ from the Paris-based Organisation for Economic Co-operation and Development (OECD).

“...ESG approaches have yet to provide consistent performance benefits based on absolute and Sharpe ratio return metrics, but do appear to help reduce lower maximum drawdown, used to assess tail risk over a specified time....and is consistent with the observed performance of some ESG products throughout the Covid-19 market stress, whereby ESG funds appeared to have lower underperformance than non-ESG counterparts,” it said.