Funds with a socially responsible or environmental, social and governance (ESG) mandate may allow clients to feel good about their investments. But new research shows that they should not expect excess returns.
As background, the popularity of sustainable, or environmental, social and governance (ESG) investing, which now accounts for one of every three dollars of total assets under management in the U.S. ($17.1 trillion) and more than half of all European investment dollars1, has been accompanied by heightened research into the subject. There are more than 1,000 research reports published. Unfortunately, they show mixed results – finding positive, negative and nonexistent correlations between ESG and financial performance. The inconclusive results may stem from the different underlying ESG data used (there is no consensus on what comprises a good company, with different raters using different metrics and measures), the varying methodologies applied (especially insofar as they control for common factor exposures), and the fact that the heightened demand for ESG investments has led to rising valuations of stocks with high ESG scores relative to stocks with low ESG scores. Increased investor demand has two effects. It leads to short-term capital gains. Ultimately, the higher valuations mean that investors should expect lower future returns over the long term.
With the mixed results in mind, Bradford Cornell and Aswath Damodaran investigated the interaction between ESG-related investment criteria and value, both from the perspective of investors wondering whether and how to incorporate social issues into investment choices, as well as from the perspective of companies considering the value effects of being more socially responsible. Their paper, “Valuing ESG: Doing Good or Sounding Good?” was published in the September 2020 issue of The Journal of Impact and ESG Investing. They looked at, “how being a ‘good’ company can make it more valuable, and the drivers of that higher value, and also how being a good company can make it less valuable, casting doubt on the sales pitch of ESG’s most ardent promoters, which is that good corporate behavior will always be rewarded with higher value.”
Cornell and Damodaran began by looking at how good companies perform on growth and profitability measures relative to bad companies. They then looked at the research on how corporate social responsibility and investment returns are related. Following is a summary of their findings:
- For ESG to increase company value, actions taken to improve ESG ratings have to result in either higher cash flows or lower risk. There is the very real possibility that being good can lower value for some firms. On the central question of whether higher ESG ratings are associated with greater risk-adjusted returns, the results are inconclusive.
- The evidence that socially responsible firms have lower discount rates, and thereby investors have lower expected returns, is stronger than the evidence that socially responsible firms deliver higher profits or growth. There are clearly firms that benefit from being socially responsible, but there are just as clearly firms where being socially responsible creates costs with no offsetting benefits. Telling firms that being socially responsible will deliver higher growth, profits and value is false advertising. In addition, many of the firms that promote ESG are successful for other reasons.
- The evidence is stronger that bad firms get punished, either with higher discount rates or with a greater incidence of disasters and shocks. ESG advocates are on much stronger ground telling companies not to be bad than telling them to be good.
- While the evidence is weak that being good improves a company’s operating performance (increases cash flows), there is more solid backing for the proposition that being bad can make funding more expensive (higher costs of equity and debt).
- Investing in companies that are recognized by the market as good companies is likely to decrease rather than increase investor returns, but investing in companies that are good, before the market recognizes and prices in the goodness, has a much better chance of success.
- There is little consistent evidence that socially responsible funds that invest in these companies deliver excess returns.
- There is no evidence that active ESG investing does any better than passive ESG investing, echoing a finding in much of active investing literature.
Cornell and Damodaran concluded: “In steady state, it is internally inconsistent to argue that good companies will benefit from lower discount rates and that investors can also earn higher returns at the same time. Thus, we are not surprised that the evidence pushes in many directions and that the pitch that investing in good companies will generate higher returns does not have stronger empirical support.”
However, they did add this important observation: “There is one possible scenario where being good benefits both the company (by increasing its value) and investors in the company (by delivering higher returns), but it requires an adjustment period, where being good increases value, but investors are slow to price in this reality. After all, concern over ESG is a relatively new phenomenon coming to the fore during the past 10 years or so; it is possible that market prices have been adjusting to a new equilibrium that reflects ESG considerations. As the market adjusts to incorporate ESG information, and assuming that the information is material to investors, the discount rate for highly rated ESG companies will fall and the discount rate for low-rated ESG companies will rise. Due to the changes in the discount rates, the relative prices of highly rated ESG stocks will increase and the relative prices of low-ESG stocks will fall. Consequently, during the adjustment period the highly rated ESG stocks will outperform the low-ESG stocks, but that is a one-time adjustment effect. Once prices reach equilibrium, the value of high-ESG stocks will be greater and the expected returns they offer will be less. In equilibrium, highly rated ESG stocks will have greater values, but investors will have to be satisfied with lower expected returns.”
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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1Depending on how you identify ESG assets, those numbers are considerably less.
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