ESG may be good for the world, but is it good for your portfolio?

• Generally, studies show that firms with higher ESG scores perform better financially than those with lower ESG scores
• However, this does not translate to the fund level, although ESG-integrated funds perform better risk-wise
• Returns may be driven by firm characteristics rather than ESG scores
• Firms with higher ESG scores may deliver higher returns in the short run and this may be further exacerbated by developments in the fund industry, albeit at the expense of long run returns

Despite the recent popularity of sustainable investing, it has been around since decades ago in the form of socially responsible investing (SRI). There have been contentious claims about the financial benefits of sustainable investing, with more than 2,000 academic studies published on this topic.

I scoured a number of studies, including two papers which summarised the numerous studies out there. I mainly looked into the relationship between financial performance and sustainable investing and between factors investing and sustainable investing.

But first, what is sustainable investing?

The two most common forms of sustainable investing are SRI and Environmental/Social/Governance (ESG) integration. SRI excludes sin stocks such as tobacco, alcohol, gambling, etc. As such, these funds have a different investable universe compared to conventional funds. Funds with ESG incorporated in their investment processes look at ratings of different ESG factors while doing their fundamental analysis and may have different inclusion characteristics.

There are other sustainable investing strategies for example:

• Norms-based screening – Investment teams eliminate companies that violate some set of norms, such as the Ten Principles of the UN Global Compact.
• Sustainability-themed investing – The fund focuses on access to clean water or climate action goals. An example would be CPR funds.
• Active ownership – Investment teams engage deeply with companies on their portfolio, with the goal of influencing the companies to improve their ESG metrics.

Now the debate is on whether investors are paying a price for more stringent investing rules. Simply put, can sustainable investing be compatible with delivering alpha?

Summary of summaries

Friede, Busch and Bassen (2015), and Clark, Feiner and Viehs (2015) have written meta-studies looking at hundreds of studies before them on the topic of sustainable investing and financial performance, with the former collating findings from more than 2000 studies.

The bottom line is that most studies conclude that there is no negative impact on returns from sustainable investing on the firm level. However, things are more inconclusive on the portfolio level with most studies reporting mixed results, although it can be said that sustainable funds do not receive a penalty for sustainable investing.

Chart 1: Results of ESG vs financial performance for firm-level and portfolio-level

Source: Figure 4 from Friede, Busch and Bassen (2015)

A paper by Morningstar (2016) also reported that “socially conscious” funds skew more towards positive ratings, i.e. higher Morningstar Ratings, as compared to the entire fund universe.

Chart 2: Morningstar Ratings of Socially Conscious Funds vs fund universe

Taken from: Morningstar Manager Research, Sustainable Investing Research Suggests No Performance Penalty. (2016)

On the firm level, the explanation for outperformance is intuitive and simple. My colleague, Sarah Chia, covered a few firms with questionable ethics in this article. Clark, Feiner and Viehs (2015) looked at the three ESG factors and examined how they affected operational performance and stock prices.

For the governance factor, studies have shown that stocks of “well-governed firms significantly outperform those of poorly-governed firms”. Similarly, firms that behave better environmentally-wise also perform better and those that do not, eventually get punished when their plans backfire, be it financially or operationally.

On the social side, Professor Alex Edmans investigated the ‘100 Best Companies to Work For’ and checked for a relationship between employee well-being and stock returns. He found that a portfolio made up of the 100 companies “earned an annual alpha of 3.5% in excess of the risk-free rate from 1984 to 2009 and 2.1% above industry benchmarks”. He repeated his study and found similar results for a period from 1984 to 2011.

Firms vs funds

Interestingly, although firms with better ESG ratings outperform those with worse ratings, the results do not extrapolate to the fund level. Varma and Nofsinger (2012) hypothesised that SRI mutual funds “run the risk of being underdiversified”, that they act as a skewed portfolio instead of an efficient portfolio.

In the skewed portfolio case, it underperforms the efficient portfolio during a bull market and outperforms during a bear market. Investors are thus inclined to hold this skewed portfolio as losses weigh heavier than gains. Richey (2016) also found that sin stocks performed in the opposite direction, thus lending credence to the hypothesis by Varma and Nofsinger.

Varma and Nofsinger (2012) found that US domestic socially responsible funds indeed outperformed during crisis periods but underperformed during non-crisis times. However, outperformance was driven by funds that focus more on shareholder advocacy and ESG issues, rather than by those that focus on negative exclusion.

ESG-driven returns or otherwise?

Firms that focus highly on ESG might have similar characteristics. Logically, firms that treat their employees well or have good governance will tend to be large firms or quality firms respectively. Companies in developed countries should also have higher ESG ratings as compared to less developed countries. Similarly, there would be ESG ratings differences across industries too.

Thus, comes the question – are excess returns driven by better ESG scores or firm characteristics and risk factors which might correlate with ESG scores?

(For those who are not curious about the question, do proceed to the conclusion.)

Kaiser (2017) regressed individual and aggregate ESG ratings against firm size and industry and found the above to be true, albeit with more nuances. Thus, there could be a possibility that ESG returns could be captured by firm characteristics, i.e. firm size, the industry, etc., or risk factors, i.e. value, growth, momentum and size.

Chart 3: Bigger firms tend to have better ESG ratings

 Source: Table 3 and 4 from Kaiser (2017)

In his paper, Kaiser had a few more findings. He first sorted firms into portfolios ranked by ESG ratings and found that the portfolio with higher ESG ratings performed worse than the one with lower ratings, although not at a statistically significant level. However, the portfolio with higher ESG ratings performed better risk-wise.

To control for the firm’s size and industry, Kaiser created adjusted ESG ratings by dividing the firm’s rating by the average ESG rating of the firm’s size’s decile and the average ESG rating of the firm’s industry. If having higher ESG ratings is beneficial for the portfolio and is independent of the firm’s size and industry, then we should see a higher differential between high and low rated portfolios, and Kaiser found exactly that.

Chart 4: Difference in returns for high ESG-rated portfolios vs low ESG-rated portfolios

 Source: Table 5, Panel A from Kaiser (2017)

In the later part of his paper, Kaiser integrated ESG ratings with factor investing. He concluded that integrating ESG led to lower systemic risk, reduction of exposure towards size, and that the risk factors are still statistically significant after ESG integration.

However, this fails to dissect whether ESG returns are driven by firms’ characteristics or risk factors. For this, we turn to a paper written by Ciciretti, Dalo and Dam (2019), where they regressed firms’ returns against firm characteristics, risk factors and aggregated ESG ratings.

Surprisingly, their findings contradict the above and factor investing too. In their findings, the only statistically significant variables were market cap, asset growth, size beta, and overall ESG score.¹ Furthermore, the coefficient for ESG score is negative; the higher the firm’s ESG score, the lower its returns are.

(Refer to Chart 5 at end of article.)

Thus, the paper concludes that ESG score contributes more to the ESG premium, as compared to the ESG risk factor. However, the ESG premium is negative – for two firms with identical characteristics, the higher ESG-rated one will tend to deliver lower returns over the lower ESG-rated one.

There might be a few factors as to why results are contradicting. Firstly, the paper is very new and relied on a recent regression methodology, thus it may be more robust in dissecting cross-sectional variations in expected returns. Furthermore, differences may arise from different time periods and different rolling periods used.

It may be possible that the other papers are less robust and rigorous, but due to resources-constraint, we simply cannot go through all of them. The fact that they are in academia should make the possibility small.

Differences in results may also arise due to the usage of different data. Ciciretti, Dalo and Dam used global firms, “covering North America, Europe, Japan, Asia Pacific ex Japan, South America, and Africa” whereas Kaiser only looked at US and European firms. The former also used aggregated ESG scores.

Conclusion to reduce confusion

As we near the end of the article, some of you may be confused about the above findings. This is what I make of them:

Firms with high ESG scores tend to deliver higher returns, as shown in the two meta-studies of many studies. These firms also perform better risk-wise and during downturns.

Firms with high ESG scores also tend to be bigger firms, or more correlated with market cap, quality and low volatility risk factors. Thus, higher returns may come from firm characteristics or risk factors, and may not necessarily be due to higher ESG scores.

That is what Ciciretti, Dalo and Dam found as after controlling for firm characteristics and risk factors betas, there is a negative premium for ESG scores. However, it is still possible for them to produce higher returns as the negative premium is low. The returns can be attributed to other sources. The negative premium applies when there are two firms with identical characteristics, less ESG score.

However, ESG scores can be used as a signal. Controlling for size and industry, Kaiser found a positive premium for portfolios of higher ESG-scoring firms. High ESG scores may contain ‘hidden information’ that are not yet incorporated in prices. These returns may come from other factors that Kaiser did not control for, which Cicirreti, Dalo and Dam did.

In the future, the ESG premium may change, as it did in the past as Ciciretti, Dalo and Dam discovered. They used the equilibrium argument as to why higher ESG scores might lead to lower returns for firms, which is an important concept for investors to know.

ESG premium puzzle

As Ciciretti, Dalo and Dam have established, investors demand firms with higher ESG scores due to their ratings. From a demand perspective, this would drive up valuations of these firms in the short run, which will tend to lead to lower returns in the long run. Inversely, “investors are only willing to hold firms with low ESG scores if they are compensated with higher expected returns, irrespective of risk considerations.”

As sustainable investing becomes more mainstream, this phenomenon should propagate itself until the equilibrium is disrupted enough, i.e. until firms with low ESG scores are unattractive enough for unconstrained investors. Also, if ESG scores do contain beneficial information that are not known yet, investors will bid up the prices until they are reflective of the firm’s characteristics.

However, in the real world that will be nigh impossible. Firstly, it is difficult to determine the firm’s true price. Secondly, due to investors’ preferences and regulations, it is likelier that we will see overbidding in the short run.

If sustainable investing is enforced heavily enough, equilibrium can be restored as firms with low ESG scores start to increase their ESG ratings too. As such, these firms are the ones with highest potentials to deliver returns over the long run, provided they are willing to improve their ESG scores. We see Asia/EMs having the highest potential for this, with funds that have high active ownership being the impetus.

Sustainable investing is indeed becoming more popular as finews.asia reported that “there were more than 2,600 PRI (Principles for Responsible Investing) signatories globally, representing USD 89 trillion of assets under management” as of end September 2019.²

If demand for ESG assets is mainly driven by investors’ preferences (although market cap may play a part) or world developments, then there may be a few ways to play this trend out. In our next article, we introduce a number of funds that you can invest in, depending on your preferences.

Do await our next article if you are one of the following:

1. You are really passionate about sustainable investing and are not fussy about returns.

2. You want returns but with lower volatility. You can also be a responsible investor as ESG-integrated funds tend to perform better risk-wise.

3. You are apathetic but want to ride on the bandwagon.

(For a deeper understanding, do read the two papers that have been talked about extensively in this article. For an easier read, Clark, Feiner and Viehs’ work is a simple and good read.)

Chart 5: Returns are mostly driven by firm’s market cap and size risk factor

  

Source: Table VI from Ciciretti, Dalo and Dam (2019)

References

Breedt, André and Ciliberti, Stefano and Gualdi, Stanislao and Seager, Philip, Is ESG an Equity Factor or Just an Investment Guide? (July 3, 2018). https://joi.pm-research.com/content/28/2/32. Available at SSRN: https://ssrn.com/abstract=3207372 or http://dx.doi.org/10.2139/ssrn.3207372

Ciciretti, Rocco and Dalo, Ambrogio and Dam, Lammertjan, The Contributions of Betas versus Characteristics to the ESG Premium (November 21, 2019). CEIS Working Paper No. 413. Available at SSRN: https://ssrn.com/abstract=3010234 or http://dx.doi.org/10.2139/ssrn.3010234

Clark, Gordon L. and Feiner, Andreas and Viehs, Michael, From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance (March 5, 2015). Available at SSRN: https://ssrn.com/abstract=2508281 or http://dx.doi.org/10.2139/ssrn.2508281

Friede, Gunnar and Busch, Timo and Bassen, Alexander, ESG and Financial Performance: Aggregated Evidence from More than 2000 Empirical Studies (October 22, 2015). Journal of Sustainable Finance & Investment, Volume 5, Issue 4, p. 210-233, 2015, DOI: 10.1080/20430795.2015.1118917. Available at SSRN: https://ssrn.com/abstract=2699610

Kaiser, Lars, ESG Integration: Value, Growth and Momentum (December 23, 2019). Available at SSRN: https://ssrn.com/abstract=2993843 or http://dx.doi.org/10.2139/ssrn.2993843

Richey, Greg. (2016). Sin Is In: An Alternative to Socially Responsible Investing?. The Journal of Investing. 25. 136-143. 10.3905/joi.2016.25.2.136.

Varma, Abhishek and Nofsinger, John R., Socially Responsible Funds and Market Crises (September 6, 2012). Journal of Banking and Finance, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2142343 or http://dx.doi.org/10.2139/ssrn.2142343

Morningstar Manager Research, Sustainable Investing Research Suggests No Performance Penalty. https://video.morningstar.com/ca/170717_SustainableInvesting.pdf

Footnotes

[1] Asset growth effect: https://quantpedia.com/strategies/asset-growth-effect/

[2] finews.asia, UOB Investment Arms Sign Up to UN-Supported Principles, https://www.finews.asia/finance/30625-uob-investment-arms-signs-up-to-united-nations-supported-principles