Sustainability Insights - ESG Investing: examining returns of broad-based vs thematic investments

Contributor

Stanko Milojević, CFA
Head of Asset Allocation, HSBC Global Private Banking and Wealth

Key highlights

Environmental, social, and governance (ESG) investing has gained widespread attention as an approach to portfolio management that can be seen as both ethically and financially sound. In this publication, we examine the data to check our belief that responsible investing can deliver competitive returns in the medium-to-long term.
Some investors will point to the experience of the recent years, during which certain ESG thematics underperformed traditional benchmarks. Our analysis, however, shows that this is largely because of the style and sector biases. In fact, broad-based ESG indices have continued to generate returns that are similar to market benchmarks.
Longer historical trends and forward-looking considerations reassure us that ESG investing remains relevant and sound. Our investment philosophy continues to emphasise the importance of remaining invested and exercising patience. We use a diversified approach to embrace the potential of ESG investing to build financial returns and contribute to a more sustainable and equitable future.

What are the data telling us?

1. Broad-based ESG indices

Figure 1 shows that the long-term performance of selected ESG indices is broadly in line with the broader market. Despite short-term deviations, ESG indices have not only kept pace with but in some cases slightly outperformed non-ESG benchmarks over longer periods. It is important to recognise that in these indices, the tilt towards ESG investments is appropriately sized to prevent excessive exposure to certain sectors, styles, or geographies. This approach to risk management is crucial for anyone venturing into thematic investments, which we explained in detail in our recent paper “How to allocate to investment themes”.

Figure 1: ESG indices performed in line with the markets over the long term

Figure 2 compares these ESG indices to the MSCI ACWI across additional metrics such as maximum drawdowns (max DD), best and worst years, and annualised performance. The analysis shows that ESG investments exhibit similar risk and return characteristics to broad market indices. While ESG can underperform slightly in certain years, it also outperforms in others—an entirely normal pattern within diversified portfolios that include some active stock selection and risk-managed deviation from the market-cap benchmark.

ESG indices underperformed market benchmarks in 2022, but it’s important to contextualise that phenomenon. The global economic landscape in recent years has been marked by rising interest rates, inflationary pressures, and sectoral shifts that have disproportionately impacted growth-oriented ESG stocks. As bond yields started to stabilise in mid-2023, we can see from the table that ESG indices once again started to perform in line with market benchmarks.

Figure 2: ESG indices vs broad benchmarks – additional statistics

We think these cyclical challenges do not detract from the structural tailwinds supporting ESG themes. Companies with robust ESG profiles are often better equipped to manage longer-term risks related to climate change, regulatory shifts, and social issues. These qualities contribute to their resilience and adaptability in an evolving global economy. But investors should remember that markets do not move in a straight line, and short-term volatility is an inherent part of market participation which equally applies to ESG investments.

2. Thematic Investments

Figure 3 sheds light on the challenges of concentrated ESG thematics compared to diversified ESG portfolios constructed using MSCI's risk-controlled methodologies. Concentrated ESG strategies can experience amplified underperformance during adverse market conditions. But this is a dynamic that is also observed in anti-ESG thematic investments, such as AdvisorShares Vice ETF and SPDR Oil and Gas Exploration ETF, which have also underperformed during the same period. This chart covers the common maximum time period across all selected ETFs. And of course, investors will appreciate that investments with a big sector or style bias can go through periods of underperformance, just as investors would not expect specific sector indices to constantly outperform through the cycle.

Figure 3: Both ESG and anti-ESG underperformed the market in recent years

This observation reinforces the importance of diversification within ESG investing. Concentrated approaches, while potentially offering higher upside in favourable environments, are more vulnerable to idiosyncratic risks. Investors can mitigate these risks by risk-sizing their thematic allocations, or using risk-managed ESG strategies that balance exposure across sectors and regions, and avoid big sector or style biases. Such diversification ensures that ESG portfolios are positioned to capture upside potential while maintaining resilience against downturns.

Figure 4 reveals that there have been years when these concentrated ESG funds substantially outperformed broader markets. Of course, no investment strategy consistently outperforms every year, and ESG is no exception. The key takeaway is that ESG investments, like all thematic strategies, require patience and a long-term perspective. An additional observation here is the negative correlation between the performance of clean energy vs oil and gas. A similar negative correlation can also be seen between the recent performance of electric vehicle manufacturers and carmakers focussed on combustion engines.

Figure 4: Calendar year performance of thematic ETFs

The strategic case for ESG investing

There is a growing body of evidence that ESG factors can contribute to financial performance over the longer term. Companies with strong ESG credentials tend to benefit from lower capital costs (source: The Impact of a Firm’s ESG Score on Its Cost of Capital, Sustainability Accounting, Management and Policy Journal), enhanced operational efficiency (source: ESG, Operational Efficiency, and Operational Performance, Managerial Finance), and improved stakeholder relationships (source: ESG Stakeholders, Implementing ESG Principles for Sustainable Businesses). As regulatory frameworks tighten and societal expectations shift, ESG leaders are well-positioned to capitalise on these trends. Recent underperformance, therefore, should be viewed as a temporary hurdle rather than a structural weakness, in our view. Some of the reasons to remain committed to integrating an ESG approach into the broader investment strategy are:

Alignment with Structural Trends: ESG investing aligns with mega-trends such as decarbonisation, resource efficiency, and social equity. These themes are not only ethically compelling but also economically advantageous in a world increasingly defined by sustainability imperatives.
Regulatory Momentum: Governments and regulators worldwide are implementing policies to address climate change, enhance corporate transparency, and promote equitable growth. ESG leaders are ahead of the curve in adapting to these changes, giving them a competitive edge.
Risk Management: Companies with strong ESG practices are better equipped to navigate reputational, regulatory, and operational risks. This risk mitigation can translate into more stable and predictable returns for investors.

Conclusion

The recent performance of thematic ESG investments may have led to questions about their viability, but it’s crucial to keep a long-term perspective. The underperformance observed in the past two years is consistent with the cyclical nature of financial markets and does not negate the structural case for the ESG approach. Evidence shows that broad-based and diversified ESG indices perform in line with broader markets over time and exhibit comparable risk profiles. By maintaining a diversified approach and focusing on long-term outcomes, investors can continue to benefit from the resilience and relevance of ESG strategies.

Our investment philosophy to stay invested and exercise patience also applies to ESG investing, as diversified portfolios should generate competitive financial returns over the long run and contribute to a more sustainable and equitable future.

HSBC and Sustainability

Today we finance a number of industries that significantly contribute to greenhouse gas emissions. We have a strategy to help our customers to reduce their emissions and to reduce our own. For more information, visit www.hsbc.com/sustainability.

Notices and disclosures

Risks of investment in fixed income

There are several key issues that one should consider before making an investment into fixed income. The risk specific to this type of investment may include, but are not limited to:

Credit risk

Investor is subject to the credit risk of the issuer. Investor is also subject to the credit risk of the government and/or the appointed trustee for debts that are guaranteed by the government.

Risks associated with high yield fixed income instruments

High yield fixed income instruments are typically rated below investment grade or are unrated and as such are often subject to a higher risk of issuer default. The net asset value of a high-yield bond fund may decline or be negatively affected if there is a default of any of the high yield bonds that it invests in or if interest rates change. The special features and risks of high-yield bond funds may also include the following:

Capital growth risk - some high-yield bond funds may have fees and/ or dividends paid out of capital. As a result, the capital that the fund has available for investment in the future and capital growth may be reduced; and
Dividend distributions - some high-yield bond funds may not distribute dividends, but instead reinvest the dividends into the fund or alternatively, the investment manager may have discretion on whether or not to make any distribution out of income and/ or capital of the fund. Also, a high distribution yield does not imply a positive or high return on the total investment.
Vulnerability to economic cycles - during economic downturns such instruments may typically fall more in value than investment grade bonds as (i) investors become more risk averse and (ii) default risk rises.

Risks associated with subordinated debentures, perpetual debentures, and contingent convertible or bail-in debentures

Subordinated debentures - subordinated debentures will bear higher risks than holders of senior debentures of the issuer due to a lower priority of claim in the event of the issuer’s liquidation.
Perpetual debentures - perpetual debentures often are callable, do not have maturity dates and are subordinated. Investors may incur reinvestment and subordination risks. Investors may lose all their invested principal in certain circumstances. Interest payments may be variable, deferred or cancelled. Investors may face uncertainties over when and how much they can receive such payments.
Contingent convertible or bail-in debentures - Contingent convertible and bail-in debentures are hybrid debt-equity instruments that may be written off or converted to common stock on the occurrence of a trigger event. Contingent convertible debentures refer to debentures that contain a clause requiring them to be written off or converted to common stock on the occurrence of a trigger event. These debentures generally absorb losses while the issuer remains a going concern (i.e. in advance of the point of non-viability). “Bail-in” generally refers to (a) contractual mechanisms (i.e. contractual bail-in) under which debentures contain a clause requiring them to be written off or converted to common stock on the occurrence of a trigger event, or (b) statutory mechanisms (i.e. statutory bail-in) whereby a national resolution authority writes down or converts debentures under specified conditions to common stock. Bail-in debentures generally absorb losses at the point of non viability. These features can introduce notable risks to investors who may lose all their invested principal.

Contingent convertible securities (CoCos) or bail-in debentures are highly complex, high risk hybrid capital instruments with unusual loss-absorbency features written into their contractual terms.

Investors should note that their capital is at risk and they may lose some or all of their capital.

Changes in legislation and/or regulation

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Nationalization risk

The uncertainty as to the coupons and principal will be paid on schedule and/or that the risk on the ranking of the bond seniority would be compromised following nationalization.

Reinvestment risk

A decline in interest rate would affect investors as coupons received and any return of principal may be reinvested at a lower rate. Changes in interest rate, volatility, credit spread, rating agencies actions, liquidity and market conditions may have a negative effect on the prices, mark-to-market valuations and your overall investment.

Risk disclosure on Dim Sum Bonds

Although sovereign bonds may be guaranteed by the China Central Government, investors should note that unless otherwise specified, other renminbi bonds will not be guaranteed by the China Central Government.

Renminbi bonds are settled in renminbi, changes in exchange rates may have an adverse effect on the value of that investment. You may not get back the same amount of Hong Kong Dollars upon maturity of the bond.

There may not be active secondary market available even if a renminbi bond is listed. Therefore, you need to face a certain degree of liquidity risk.

Renminbi is subject to foreign exchange control. Renminbi is not freely convertible in Hong Kong. Should the China Central Government tighten the control, the liquidity of renminbi or even renminbi bonds in Hong Kong will be affected and you may be exposed to higher liquidity risks. Investors should be prepared that you may need to hold a renminbi bond until maturity.

Alternative Investments

Hedge Fund - Please note Hedge Funds often engage in leveraging and other speculative investment practices that may increase the risk of investment loss. They can also be highly illiquid, are not required to provide periodic pricing or valuation information to investors, and may involve complex tax structures and delays in distributing important information. Alternative investments are often not subject to the same regulatory requirements as, say, mutual funds, and often charge high fees that may potentially offset trading profits when they occur.

Private Equity - Please note Private Equity is generally illiquid, involving long term investments that do not display the liquid or transparency characteristics often found in other investments (e.g. Listed securities). It can take time for money to be invested (cash drag) and for investments to produce returns after initial losses.

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Investment in emerging markets may involve certain, additional risks which may not be typically associated with investing in more established economies and/or securities markets. Such risks include (a) the risk of nationalization or expropriation of assets; (b) economic and political uncertainty; (c) less liquidity in so far of securities markets; (d) fluctuations in currency exchange rate; (c) higher rates of inflation; (f) less oversight by a regulator of local securities market; (g) longer settlement periods in so far as securities transactions and (h) less stringent laws in so far the duties of company officers and protection of Investors.

Risk disclosure on FX Margin

The price fluctuation of FX could be substantial under certain market conditions and/or occurrence of certain events, news or developments and this could pose significant risk to the Customer.

Leveraged FX trading carry a high degree of risk and the Customer may suffer losses exceeding their initial margin funds. Market conditions may make it impossible to square/close-out FX contracts/options. Customers could face substantial margin calls and therefore liquidity problems if the relevant price of the currency goes against them.

The leverage of a product can work against you and losses can exceed those of a direct investment. If the market value of a portfolio falls by a certain amount, this could result in a situation where the value of collateral no longer covers all outstanding loan amounts. This means that in-vestors might have to respond promptly to margin calls. If a portfolio’s return is lower than its financing cost then leverage would reduce a portfolio’s overall performance and even generate a negative return.

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When an investment is denominated in a currency other than your local or reporting currency, changes in exchange rates may have a negative effect on your investment.

Chinese Yuan (“CNY”) risks

There is a liquidity risk associated with CNY products, especially if such investments do not have an active secondary market and their prices have large bid/offer spreads.

CNY is currently not freely convertible and conversion of CNY through banks in Hong Kong and Singapore is subject to certain restrictions. CNY products are denominated and settled in CNY deliverable in Hong Kong and Singapore, which represents a market which is different from that of CNY deliverable in Mainland China.

There is a possibility of not receiving the full amount in CNY upon settlement, if the Bank is not able to obtain sufficient amount of CNY in a timely manner due to the exchange controls and restrictions applicable to the currency.

Illiquid markets/products

In the case of investments for which there is no recognised market, it may be difficult for investors to sell their investments or to obtain reliable information about their value or the extent of the risk to which they are exposed.

Environmental, Social and Governance (“ESG”) Customer Disclosure

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HSBC may rely on measurement criteria devised and reported by third party providers or issuers. HSBC does not always conduct its own specific due diligence in relation to measurement criteria. There is no guarantee: (a) that the nature of the ESG / sustainability effect of, or measurement criteria for, an investment will be aligned with any particular investor’s sustainability goals; or (b) that the stated level or target level of ESG / sustainability effect will be achieved. ESG and Sustainable investing is an evolving area and new regulations and coverage are being developed which will affect how investments can be categorised or labelled in the future.

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Transactions which you enter into with an entity or branch other than The Hongkong and Shanghai Banking Corporation Limited, Sydney Branch, does not represent a deposit with, or a liability of, The Hongkong and Shanghai Banking Corporation Limited, Sydney Branch. Unless expressly stated otherwise in any document, The Hongkong and Shanghai Banking Corporation Limited, Sydney Branch does not stand behind, or support by way of guarantee or otherwise, the obligations of any other related entity of the HSBC Group (including HSBC Bank Australia Limited). Transactions you enter into with a branch of The Hongkong and Shanghai Banking Corporation Limited other than the Sydney Branch, will not be booked in Australia and is not a transaction with the Sydney Branch.

The Hongkong and Shanghai Banking Corporation Limited also does not guarantee the performance of any products of another HSBC Group entity or branch.

Transactions you enter into with another HSBC Group entity is exposed to a variety of risks such as investment risk, including possible delays in repayment and loss of income and principal invested.

As a foreign ADI, provisions in the Banking Act 1959 (Cth) for the protection of depositors do not apply to The Hong Kong and Shanghai Banking Corporation Limited, Sydney Branch. For example, depositors with foreign ADIs do not receive the benefit of the following protections:

Deposits are not covered by the financial claims scheme and are not guaranteed by the Australian Government.
Deposits do not receive priority ahead of amounts owed to other creditors. This means that if a foreign ADI was unable to meet its obligations or otherwise is in financial difficulties and ceases to make payments, its depositors in Australia would not receive priority for repayment of their deposits from the foreign ADI's assets in Australia.

A foreign ADI is not required to hold assets in Australia to cover its deposit liabilities in Australia. This means that if the foreign ADI were unable to meet its obligations or otherwise is in financial difficulties and ceases to make payments, it is uncertain whether depositors would be able to access the full amount of their deposit.

In mainland China, this material is distributed by HSBC Bank (China) Company Limited (“HBCN”) to its customers for general reference only. This document has no contractual value and is not and should not be construed as an offer or the solicitation of an offer or a recommendation for the purchase or sale of any investment or subscribe for, or to participate in, any services. HBCN is not recommending or soliciting any action based on it.

In UAE (onshore), this material is distributed by HSBC Bank Middle East Limited UAE Branch, which is regulated by the Central Bank of UAE, for the purpose of this promotion and lead regulated by the Dubai Financial Services Authority. In respect of certain financial services and activities offered by HSBC Bank Middle East Limited UAE Branch, it is regulated by the Securities and Commodities Authority in the UAE under license number 602004. The material contained in this document is for general information purposes only and does not constitute investment research or advice or a recommendation to buy or sell investments.

In Kuwait, this material is distributed by HSBC Bank Middle East Limited, Kuwait Branch (HBME KUWAIT) which is regulated by the Central Bank of Kuwait, Capital Markets Authority for licensed Securities Activities and lead regulated by the Dubai Financial Services Authority. This document is directed to clients of HBME KUWAIT and should not be acted upon by any other person. HBME KUWAIT is not responsible for any loss, damage or other consequences of any kind that you may incur or suffer as a result of, arising from or relating to your use of or reliance on this document. The content of this document is for general information purposes only and does not constitute the offering of advice or recommendation to invest and should not be used as the basis for any decision to buy or sell investments.

In HSBC India, this material is distributed by Hongkong and Shanghai Banking Corporation Limited, India (“HSBC India”). HSBC India is a branch of the Hongkong and Shanghai Banking Corporation Limited. HSBC India is a distributor of select mutual funds and referrer of investment products from third party entities registered and regulated in India. HSBC India does not distribute investment products to those persons who are either the citizens or residents of United States of America (USA), Canada or any other jurisdiction where such distribution would be contrary to law or regulation. HSBC India, will receive commission from HSBC Asset Management (India) Private Limited, in its capacity as a AMFI registered mutual fund distributor of HSBC Mutual Fund. The Sponsor of HSBC Mutual Fund is HSBC Securities and Capital Markets (India) Private Limited (HSCI), a member of the HSBC Group. Please note that HSBC India and the Sponsor being part of the HSBC Group, may give rise to real, perceived, or potential conflicts of interest. HSBC India has a policy in place to identify, prevent and manage such conflict of interest. HSBC India provides non-discretionary portfolio advisory services for select Private Banking customers under the SEBI (Portfolio Managers) Regulations, 2020 (“PMS Regulations”) vide registration no. INP000000795. Performance of each portfolio may vary for each investor because of 1) the timing of inflows and outflows of funds; and 2) differences in the portfolio composition because of restrictions and other constraints. ‘Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

For SAA/TAA

This is an illustrative approach of a globally diversified portfolio allocation strategy across asset classes; the strategy and the underlying fulfilment options are not applicable to India customers.

Where your location of residence differs from that of the HSBC entity where your account is held, please go to HSBC Global Private Banking website > Disclaimer > Cross Border Disclaimer for disclosure of cross-border considerations regarding your location of residence.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted, on any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of HSBC.

A complete list of private banking entities is available on our HSBC Private Bank website.

Insights & Research (I&R) Disclaimer

For the avoidance of doubt the making available by HSBC to you of this document solely through the Global Private Banking Insight & Research (I&R) shall not constitute solicitation of the sale or recommendation of any product or service and is subject to the terms of the Services agreement. You should contact your Relationship Manager or Investment Counsellor at HSBC if you wish to enter into a transaction for an investment product.

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