Pecunia non olet – money does not stink  – is a well-known Latin saying. Can this also be said of returns? Therefore, if money does not stink, must the same apply to the return? In the context of sustainable investment, this would require that the market is always able to separate the wheat from the chaff – sustainable from unsustainable companies. One prerequisite for this is that the risks of environmentally damaging or unsocial company practices are correctly priced by the market. If all external effects are included in the price of an investment, the return has already been corrected for the sustainability effect. As a logical consequence, investors would not have to deal with the issue of sustainability and could leave it to the market. However: Are the market incentives strong enough and clear enough for listed companies worldwide to strive for virtuous behaviour?
Does the market create incentives for virtuous behaviour?
The classic financial market theory is based on the hypothesis of an (information) efficient market which is able to immediately incorporate all relevant information about a company into its stock price. Companies whose behaviour is unsustainable would thus be classified as riskier by the market: they would have to make more effort to finance themselves on the market and would be penalised with a lower valuation. That alone would be incentive enough to comply as much as possible with sustainability principles.
So what is the market exactly? It is in fact an impersonal entity which reflects only the average of all investors. However, investors are not always rational – even on average. Their behaviour is often short-sighted and driven by greed and fear.
The self-regulation function of the market is therefore questioned by supporters of behavioral finance. They doubt whether one can actually price in sustainable behaviour in a globalised financial market, especially since, as will be described in the following paragraph, there are no globally valid sustainability standards.
Not everyone understands sustainability in the same way
What does sustainable investing really mean? Despite everyone talking about it, sustainability cannot be defined by objective and universal principles. To stake out the topic one speaks today of ESG representing the three areas environment, social and governance. In their interpretation the zeitgeist along with diverse cultural, social and geographic sensibilities, play a crucial role. From slavery to child labour to pollution: practices that were once considered normal are – fortunately – no longer tolerated today. For example, smoking: Remember the legendary television debates, where gesticulating guests were barely recognisable through the cigarette smoke – from today’s perspective unthinkable! Historically, there have been very big differences in the perception and acceptance of ESG criteria and these differences are still strong today. A survey of friends about the definition of sustainability and priorities in the application of ESG principles will produce different answers. Personal values are shaped by social and societal sensibility. What is especially striking are the differences between regions, continents and cultures, which in turn influence how urgently a certain sustainability criterion is being called for from various groups of investors.
Private investors can determine their ideas regarding sustainability and its implementation in an individual investment strategy and consciously accept the costs or opportunity costs. This is immeasurably more complicated for institutional investors who, like insurance companies or pension funds, manage funds for a large number of beneficiaries on a fiduciary basis. They face several problems (at once): What is the common denominator of investors regarding ESG criteria? How restrictive should their application be and upon which ESG definition should the criteria be based? Does an ESG committee have to be called? How detailed should the ESG investment process be in the rules and regulations? How to define governance and control processes? In addition, a further question which, in view of the lower return expectation, is utterly existential: how does the consideration of ESG criteria influence performance?
Sustainability and the return issue
So far there has been no scientifically conclusive answer as to whether and how the inclusion of ESG criteria has a positive or negative effect on returns. In the last 20 years, several studies have been published, sometimes with very different results, not least because of the underlying data, methodology used and definition of ESG criteria. Simply put, two groups can be distinguished: The first one expects the integration of ESG to have a negative effect on returns. This view is supported by empirical analyses which show that sin stocks regularly outperform the market. These include companies which behave in compliance with the law, but operate in less sustainable and responsible business areas such as alcohol, tobacco, gambling and weapons. The Sin Stocks Report  also includes companies which attract negative attention through very aggressive sales practice – for example, in the allocation of consumer credit – or by exploitative working conditions.
The other group believes that companies guided by higher ESG standards also have better risk control, which has a long-term positive impact on returns.
According to Cliff Asness, founder of the asset management company AQR and widely recognized professional also in scientific circles, the inclusion of ESG cannot lead to a higher return because, compared to an investment process without restrictions, the investment universe is limited. Sustainable investing therefore contradicts the goal of achieving the highest possible return, or in other words: “virtue is not a free lunch” . Investors who ban certain securities from the portfolio due to ESG restrictions push their price down. Underpricing induced by selling pressure increases the expected return for investors who are not concerned about ESG. This assessment is confirmed in the long-term outperformance of sin stocks. This empirical evidence seems to confirm that there is a price to pay by including ESG – a loss in return.
Is there sinful excess return?
Even though companies known as sin stocks do not cover or violate all ESG categories, their performance has been the subject of numerous scientific studies. They thus represent the longest and best-analysed data series to evaluate the implications and opportunity costs of investing sustainably in a portfolio.
A study which goes back the furthest is one which includes US equity data from the 1920s onwards. The results are unambiguous: regardless of whether aggregated or broken down into individual sins, immoral investments consistently outperform the market index .
A similar conclusion is reached in an extensive study by Fabozzi, Ma and Oliphant, which takes into account the performance of sin stocks from 21 countries . Between 1970 and 2007, both the aggregate international sin portfolio and individual sin country portfolios clearly outperformed the market capitalised index.
In a meta-study, Dimson, Marsh and Staunton  identify the factors behind the above average returns of sin stocks: they can count on stable demand for their products and services, operate internationally and boast a high margin. In addition, they are shielded from competition thanks to a high market entry threshold. As soon as a majority of investors avoid these stocks for ethical reasons, this can create a buying opportunity for investors who are not concerned about ESG criteria.
Our own analysis in Figure 1 (based on the MSCI ESG database ) shows the performance of each MSCI ESG rating category – from AAA as the highest rating to CCC as the lowest rating – for the MSCI Equities World Index over the last ten years. The chart shows that an investment in equities from the worst and best rating categories promises an above-average return. Accordingly, a passive, market cap weighted approach to the exclusion of equities with CCC ratings would result in lower portfolio return. A difficult starting position for institutional investors with a passive investment strategy who have to integrate ESG criteria into their investment process but cannot accept performance losses!