According to Refinitiv, ESG issues will be a dominant investor theme of the 21st century. Not everyone agrees. The newest research disputes the claim that ESG funds outperform and considers the ESG narrative a marketing trick. Do ESG investments truly produce value?
What’s ESG?
ESG stands for Environmental, Social and Governance. These are standards for companies that investors use to screen potential investments. Global challenges, such as sea-level rise, data security and demographic shifts, affect the way investors, particularly millennials and women, view their investments. According to the Bank of America, over the next two to three decades, the millennials could put between $15 trillion and $20 trillion into US-domiciled ESG investments.
ESG Metrics
ESG has been growing since the 1960s under the umbrella term of socially responsible investing. Recently, it became even more important as more investors incorporate ESG factors into their investment process and leading institutions implement ESG strategies.
However, ESG metrics are not a part of mandatory financial reporting. There are no established standards of ESG, no clear definition and no uniform method of measuring it. Depending on the index provider, each factor might differ. ESG standards are not standardized and it shows the industry is not as committed as it pretends to be to implementing ESG strategies.
Some institutions, such as the Sustainability Accounting Standards Board (SASB) or the Global Reporting Initiative (GRI) work on establishing a common standard. Although it is still a work in progress.
ESG and Performance
The question we have to ask is whether incorporating ESG factors into the investment process will hurt performance.
MSCI researchers identified three major channels from ESG to financial value. They found that companies with higher ESG ratings were more competitive and generated abnormal returns, experienced a lower frequency of idiosyncratic risk incidents and have shown lower systematic risk exposure, evidenced by less volatile earnings and less systematic volatility.
The ESG factors are connected and overlap. Their implementation can create value for the company as investors look for strong ESG factors. According to McKinsey, a strong ESG proposition correlates with higher equity returns, from both a tilt and momentum perspective. Studies on the impact of ESG propositions on equity returns showed a 63% share of positive findings.
As to the impact of Covid-19, Refinitiv evaluated that the most conventional funds have underperformed their respective technical indicators, while the majority of ESG funds have outperformed their technical indicators.
Newest Research
According to the newly published research on ESG, the widely held belief that “sustainable” investing delivers outperformance is a mirage and the above-market returns are achieved by exposure to so-called style factors long known to boost investment returns.
Scientific Beta found that three-quarters of the outperformance is due to “quality” metrics, such as high profitability and conservative investment. It is disputed to what extent ESG and quality overlap in the research of ESG standards.
ESG’s Ability to Produce Value
Implementing ESG factors into the investment process has its value. Investing in companies that align with investors’ ethical code will breed beneficial investments. Companies will make an effort to implement ESG strategies. There is a risk of green-washing, but there might be some real effort there.
However, it remains to be seen whether ESG funds outperform their traditional counterparts. It must be said that bigger companies tend to have better ESG strategies in place simply because they can afford the time and space required to do it.
Do they have better developed other areas as well which contribute to the performance? Probably yes. It is not entirely clear what causes the outperformance, but ESG should remain on the investors’ mind regardless.
Conclusion
ESG became a hot topic in the investing world. With so many social and environmental changes on the horizon, millennials gaining investing power and the pandemic, ESG will rise in popularity. However, it remains to be seen whether ESG can produce alpha and ensure outperformance.
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