The doing-well-by-doing-good conviction driving ESG investors around the world is nothing more than an illusion of their own making, according to a controversial new study.
Research from the Swiss Finance Institute argues stocks highly rated on environmental, social and governance metrics have outperformed in recent years all thanks to the trillions of dollars flooding the sector. The fundamentals of socially responsible investing have played no role in driving these returns.
In fact, ESG bets would have backfired spectacularly without this influx of cash -- leaving Wall Street portfolios at the mercy of volatile capital flows.
“Under the absence of flow-driven price pressure, the aggregate ESG industry would have strongly underperformed the market from 2016 to 2021,” Philippe van der Beck said in the “Flow-Driven ESG Returns” paper published this month. “If however, ESG inflows unexpectedly revert, the realized future return may be strongly negative.”
It’s the latest contribution to the raging debate on the “have your cake and eat it” pitch driving the industry, which as of last year has amassed a whopping $35 trillion in assets.
Proponents argue there’s evidence an ESG framework can help pick winning stocks by seizing on the broader fight against climate change and social inequities -- making Tesla Inc. more attractive than Exxon Mobil Corp., for example. Even if there is something to van der Beck’s analysis, profound global changes will still boost ESG shares far into the future.
To the researcher, the point is that flows have so far driven industry performance -- more than commonly acknowledged. Just as retail traders were able to power seemingly deadbeat companies to dizzying highs this year from GameStop Corp. to AMC Entertainment Holdings Inc., prices of stocks bought by ESG investors will naturally rise -- even without any fundamental justification.
Van der Beck’s conclusions are rooted in the Inelastic Markets Hypothesis, a new theory about asset prices that’s been gaining traction. His takeaway: Moving $1 from a regular market portfolio to a typical ESG one boosts the value of stocks favored by the latter by as much as $2.50. Without inflows, a long-short ESG strategy would have recorded “significantly negative” alpha.
The author calculates what returns would have been without all that cash by putting a number on each stock’s appeal to socially conscious funds and its price reaction to flows.
The study has drawn more downloads than the average equation-filled finance paper since it was posted last week on the Social Science Research Network. Jean-Philippe Bouchaud, chairman of quant hedge fund Capital Fund Management, concurred with the conclusions on LinkedIn.
It dovetails with similar warnings including from the Bank of International Settlements in September that the explosion in green financing may be fueling a bubble akin to the dot-com mania. An S&P index of global clean energy stocks trades at 44 times its earnings, double that of large-caps overall.
There’s no shortage of academic papers on the mystery of green-stock outperformance specifically. In the classic economic theory promulgated by Eugene Fama, the opposite should occur -- investors’ sheer taste for ESG should push up valuations and lead to worse returns over the long haul.
In an academic paper last month, Lubos Pastor of the University of Chicago and Robert Stambaugh and Lucian Taylor of the University of Pennsylvania wrote that without fund inflows and the cacophony of climate headlines, the “green factor” in stocks would indeed have lost money in the eight years through 2020.
“Should green stocks’ recent outperformance lead one to expect high green returns going forward?” they said. “No, we argue. That outperformance likely reflects an unanticipated increase in environmental concerns.”
Yet this is all unlikely to sway ESG believers that see a future where climate fears will only intensify further. Still, industry supporters and detractors agree on one thing: Putting more money in the likes of green companies can deliver change by lowering their cost of capital.
“ESG investing will surely not solve on its own the climate change problem, but its impact could be far from inconsequential provided flows become large enough in the coming years,” CFM’s Bouchaud wrote on LinkedIn.
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