Does placing ESG restrictions around investments hinder performance?

Debates about environmental, social and governance (ESG) investing often focus on a single concern: if you restrict the investment universe, do you sacrifice returns, especially from unloved, “undervalued” stocks? Evidence from global ESG indices and recent research suggests the relationship between ESG restrictions and performance is more complex than a simple trade-off.

ESG is broader than “green tech”

One misconception is that ESG investing is limited to renewable energy or clean technology. In reality, ESG frameworks apply to all sectors and extend well beyond environmental themes:

• Governance: board independence, shareholder rights, risk controls, audit quality.
• Social factors: workforce safety and engagement, diversity, supply-chain standards, community impact.
• Environmental management: energy use, pollution, resource efficiency, transition planning.
  

Viewed this way, ESG is not about narrowing the world to a handful of “green” names; it is about widening the analytical lens on every company. This broader lens can help distinguish between firms that are cheap for good reason and those that are genuinely mispriced.

Historical data from global ESG benchmarks shows that applying sustainability criteria need not penalise returns. For example, an index of companies with stronger ESG profiles such as a Socially Responsible Investing (SRI) universe that selects roughly the top quartile of names by ESG quality has, over the past decade, delivered a modest but persistent annualised return premium relative to its parent index.

Past performance is never a guarantee, and there have been years when excluded sectors outperformed.

Yet, over longer horizons, ESG leaders tended to share common features:

• Solid balance sheets and cash flows
• Disciplined capital allocation and governance
• Lower earnings volatility, on average, more attractive and stable dividend yields
  

In other words, robust fundamentals, not just capital flows into “sustainable” labels, appear to have supported returns.

When ESG restrictions screen for controversial sectors or laggard companies, critics argue that investors are leaving “undervalued” opportunities on the table. That can happen in specific periods. However, low valuations in ESG-challenged sectors often reflect real risks:

• Exposure to tightening environmental regulation
• Potential legal liabilities and remediation costs
• Reputational damage that erodes pricing power
• Governance failures that can lead to abrupt value destruction
  

A company may look inexpensive on traditional metrics precisely because the market is beginning to discount these issues.

Research increasingly treats ESG as a distinct financial factor rather than a mere proxy for quality or momentum. Over different periods, various ESG dimensions have contributed differently to returns:

• Environmental and governance factors were key drivers when climate risk, scandals and accountability were in focus.
• More recently, social topics such as workforce well-being and diversity have gained importance as societal expectations evolve.
  

Because these drivers shift over time, ESG provides an additional and dynamic perspective on resilience and adaptability. This can be especially relevant for long-term investors who care about how business models will perform across regulatory, technological and social transitions.

What long‑term performance data tells us about ESG screening

The performance of the MSCI All Countries World Index and its ESG‑filtered counterparts shows that applying sustainability screens has had little impact on long‑term returns. Over the past decade, the standard MSCI ACWI delivered 12.8% annualised, while the ESG‑screened version edged slightly higher at 13.0%, and the ESG Selection index matched the broad market at 12.8%. The pattern holds over three‑ and five‑year horizons too, with all indices clustering closely together, around 19% over three years and roughly 12% over five years. Taken together, the data suggests that excluding controversial sectors or favouring stronger ESG performers has not materially hindered returns, challenging the idea that ESG screens inherently compromise performance.

The role of greenwashing and standards

As ESG assets have grown, greenwashing has become a major concern. Without clear definitions and transparent data, restrictions can be applied inconsistently, undermining both credibility and performance analysis. Strong standards, independent research and robust reporting frameworks are therefore essential to ensure that ESG criteria genuinely reflect material risks and opportunities and investors know what is included, excluded and why. Better standards support better investment decisions and make performance comparisons more meaningful.

For institutions like LGT, sustainability is not an add-on but part of long-term stewardship and alignment with global frameworks such as the Paris Agreement and the UN Sustainable Development Goals. Within that philosophy, ESG is used to help identify businesses that can navigate structural change while maintaining financial strength.

At LGT, we actively use our clients’ shareholder rights to engage in constructive, transparent dialogue with company boards and senior executives. Effective stewardship is not about directing companies but about holding them to account on their ESG commitments and supporting them to drive meaningful, lasting change. Through thoughtful challenge and open conversation, investors can prompt greater transparency, stronger governance, and more sustainable business practices.

In 2025, our stewardship work led to more than 50 high quality company engagements, many of which delivered tangible progress. A few notable outcomes include:

• Novartis: Introduced publicly disclosed biodiversity targets following our engagement.
• Nestlé: Committed to conducting water basin level risk assessments and mapping raw ingredients against biodiversity integrity layers.
• NextEra: Published its first-ever human rights policy, marking an important step forward in social transparency.

These examples demonstrate how informed, persistent engagement can influence positive corporate behaviour. By opening conversations directly with CEOs and board members, shareholders can challenge organisations in a constructive way not by imposing demands, but by highlighting risks, opportunities, and the benefits of responsible action. What companies choose to disclose, the commitments they make, and the steps they take toward improvement are strengthened when shareholders use their voice with purpose and consistency.

So, do ESG restrictions hinder performance by excluding undervalued stocks? They may, in certain cycles, mute exposure to segments that temporarily outperform. But over longer horizons, incorporating ESG tends to filter out companies with elevated, often under priced risks and highlight firms with stronger governance and more stable fundamentals.

Rather than a binary choice between ethics and earnings, ESG-informed investing seeks to combine competitive financial returns with positive environmental and social outcomes. The key is not whether restrictions exist, but how thoughtfully they are designed, transparently implemented and continuously reviewed in light of evolving evidence.