New research shows that higher employee satisfaction leads to higher equity returns. That reinforces previous research showing that environmental, social and governance (ESG) principles should be an important aspect of advisors’ due diligence in fund selection.

ESG has been one of the fastest growing investment phenomena, and academic research has focused on this subject. As a result, companies and investment firms have taken notice. For example, in August 2019 the Business Roundtable, which represents nearly 200 CEOs of America’s biggest companies, announced the end of shareholder primacy and called for the role of a corporation to be redefined, suggesting that a large number of firms view sustainability issues as strategically important. In addition, BlackRock CEO Larry Fink sent a letter to investors in January 2020 detailing his plans to incorporate ESG as a new standard for investing. Investment managers who signed the UN Principles for Responsible Investment had over $90 trillion in assets under management in 2019. ESG investing now accounts for one out of every four dollars under professional management in the United States and one out of every two dollars in Europe.

The popularity of ESG investing has impacted the cost of capital of companies. Because ESG investors favor companies with high ESG scores and avoid those with low ESG scores, those with low ESG scores will tend to have higher costs of capital, putting them at a competitive disadvantage. Thus, one positive result of the popularity of ESG investing is that it is causing companies to focus on improving their ESG scores to lower their cost of capital.

For example, the research, including the 2019 study, “Foundations of ESG Investing: How ESG Affects Equity Valuation, Risk and Performance,” found that companies with higher ESG scores have above-average risk control and compliance standards across the company and within their supply chain management. Because of better risk-control standards, high ESG-rated companies suffer less frequently from severe incidents such as fraud, embezzlement, corruption or litigation cases that can seriously erode the value of the company and its stock price. Less frequent risk incidents ultimately lead to less downside, or tail, risk in the company’s stock price and thus higher valuations and lower costs of capital. However, the increased cash flows to companies with favorable ESG scores has two effects. It leads to rising valuations and thus short-term capital gains.

Ultimately, those higher valuations mean that investors should expect lower future returns over the long term.