The Non-Performance Benefits of ESG Investing
New research confirms that investing with an environmental, social and governance (ESG) mandate does not lead to higher risk-adjusted returns. But investors will reduce exposure to climate-related risks and get the “psychic” benefit of making a positive impact for society.
Interest in ESG investing is motivated by the desire to align portfolios with investors’ values and norms; make a social impact by pushing companies to act responsibly; reduce exposure to risks, such as climate or litigation risk, faced by ESG laggards; and generate performance by favoring ESG leaders. On the last point, the research into the results of ESG investment strategies has produced conflicting results, with some papers finding that ESG investments have provided higher returns, while others found the reverse to have been the case.
In particular, older papers tended to show underperformance (there was a sin premium to owning “brown” stocks), while more recent papers reported mixed results, with some showing outperformance for ESG strategies.
The reason for the mixed results is that the research is complicated by conflicting forces – investor preferences lead to different short- and long-term impacts on asset prices and returns. Firms with high sustainable investing scores earn rising portfolio weights, leading to short-term capital gains for their stocks – realized returns rise temporarily. However, the long-term effect is that higher valuations reduce expected long-term returns. The result can be an increase in green asset returns even though brown assets earn higher expected returns.
In other words, there is an ambiguous relationship between carbon risk and returns in the short term.
With the mixed results in mind, Bradford Cornell and Aswath Damodaran investigated the interaction between ESG-related investment criteria and value. Their paper, “Valuing ESG: Doing Good or Sounding Good?,” was published in the September 2020 issue of The Journal of Impact and ESG Investing. These were among their key findings:
- 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.
- The evidence is stronger that bad firms get punished, either with higher discount rates or 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.
Giovanni Bruno, Mikheil Esakia and Felix Goltz contribute to the literature with their April 2021 study, “‘Honey, I Shrunk the ESG Alpha’: Risk-Adjusting ESG Portfolio Returns,” in which they sought to determine whether evidence supporting recent claims that ESG strategies generate outperformance was accurate. To make that determination, they constructed 12 ESG strategies that had been shown to outperform in popular papers. They then assessed the performance benefits to investors after accounting for sector and factor exposures, downside risk and attention shifts. They used monthly ESG ratings data from MSCI (also known as IVA for “intangible value assessment”) from January 2007 to June 2020. ESG ratings range from 0.0 to 10.0, with a high score indicating strong performance on ESG issues. They used the component scores for the environmental (E), social (S), and governance (G) components of the overall rating. They used the scores, as published by MSCI, to design strategies that focused on one component. In addition, they used aggregate ESG scores. They then constructed the aggregate ESG score of a firm as the weighted average of the component scores.
They then designed long/short strategies that captured performance differences between ESG leaders and ESG laggards: At each monthly rebalancing date, they selected 30% of the stocks with the highest ESG scores in the long leg, and 30% of stocks with th%e lowest score in the short leg. The rebalancing date was the third Friday of the calendar month. Stocks within the long and the short leg were equally weighted. They then evaluated strategy returns from January 2008 to June 2020. They constructed three types of strategies, following popular industry papers:
- Overall ESG score and component scores (E, S and G): selecting stocks based on their overall ESG score, or the score for one of the three components, leading to four different strategies.
- ESG momentum score: selecting stocks based on their ESG Momentum, defined as the change of their ESG score over 12 months.
- Combined score (ESG and ESG momentum): selecting 30% of stocks in the long leg by selecting 40% of stocks with the highest ESG score and then excluding 10% of stocks with the lowest ESG momentum. Similarly, the short leg selected 40% of stocks with the lowest ESG score and then excluded 10% of stocks with the highest ESG momentum.
They then measured the level of returns of ESG strategies that did not come from exposure to standard factors, employing a standard time-series regression. Their multifactor model included seven factors: the market, value, size, momentum, low volatility, high profitability and low investment factors. Following is a summary of their conclusions:
- When accounting for exposure to standard factors, none of the 12 different strategies constructed to tilt to ESG leaders added significant outperformance, whether in the U.S. or in developed markets outside the U.S. Across the different ways of using ESG ratings to build the strategies and across the two universes, none of the estimates of multifactor alpha were significantly different from zero – implying that an investor cannot improve their Sharpe ratio by using these ESG strategies.
- Seventy-five percent of CAPM alpha outperformance was due to quality factors that were mechanically constructed from balance sheet information.
- ESG strategies have pronounced sector biases, except in the case of the ESG Momentum strategy. For example, in the U.S., ESG strategies overweight technology stocks. And sector neutrality weakens the performance of the ESG strategies.
- ESG strategies do not offer significant downside risk protection – accounting for exposure of the strategies to a downside risk factor does not alter the conclusion that there is no value-added beyond implicit exposure to standard factors such as quality (quality companies tend to be large, profitable and invest conservatively). In other words, ESG strategies tend to be large-cap quality strategies. Over the sample period, an investor who tilted to quality factors with the same intensity as the U.S. ESG strategy would have outperformed the ESG strategy.
- Recent strong performance of ESG strategies can be linked to an increase in investor attention – flows into sustainable mutual funds showed that attention to ESG rose remarkably over the later period of their sample, from about 2013. Alpha estimated during low attention periods was up to four times lower than alpha during high attention periods, and at times even turned negative. Therefore, studies that focus on the recent period tend to overestimate ESG returns.
Their findings led Bruno, Esakia and Goltz to conclude: “Claims of positive alpha in popular industry publications are not valid because the analysis underlying these claims is flawed. Omitting necessary risk adjustments and selecting a recent period with upward attention shifts enables the documenting of outperformance where in reality there is none.”
Their conclusion is consistent with the observation by Cornell and Damodaran, who stated: “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.”
The above findings should not lead to questioning whether ESG strategies can offer substantial value to investors. Instead, they suggest that investors who look for value-added through outperformance are looking in the wrong place – ESG strategies should be considered for the unique benefits they can provide, such as hedging climate or litigation risk, aligning investments with norms and making a positive impact for society. In addition, ESG investors get an added benefit by employing strategies that tilt toward factors with higher expected returns – a strategy employed by the sustainable investment funds of Dimensional.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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