Ethical investing has attracted a lot of attention, and billions of funds, in recent years. However, the true impact of Environment Social and Governance (ESG) investing on portfolio returns is hotly debated.
In a recent paper, researchers suggest that firms do suffer for their bad behavior, but that benefits from an ESG focus are harder to find, both in companies’ financials and their investors’ returns. This is consistent with recent research that found that favorable ESG ratings may not have been a key factor in the stocks that did well during the pandemic period.
In their paper ‘Valuing ESG: Doing Good or Sounding Good?’ researchers Bradford Cornell and Aswath Damodaran attempt to unpack the details of ESG investing. Of course, few dispute that ESG investing is likely to be helpful in creating more responsible companies. However, beyond that the data is mixed.
The researchers examine the frequent assertion that an ESG orientation can improve company performance and with it investor returns. This question is complex, not least because there is no agreement on how ESG scores should be defined.
They find no real evidence, when examining multiple studies, that an ESG orientation improves shareholder returns or corporate performance. However, they also note that as a relatively recent theme, there is some limit as to what can be gleaned from existing data.
Breaking The Rules
Two main themes though emerge from their examination of ESG investing. The first is that those companies that strongly violate ESG norms do appear to underperform the market. On a risk-adjusted basis this works out to a performance drag of around 3.5% a year, according to researcher Simon Glossner. That’s pretty material as these sort of effects go.
So though the evidence that a strong ESG ranking boosts returns is mixed, there may be clearer evidence that poorly ranked firms on ESG criteria underperform the market. For example events such as oil spills, product recalls and lawsuits may carry a cost that eats into profits. As such, being a star, in ESG terms may not deliver a benefit, but being a bad company brings additional costs and hurts returns for investors.
The second finding is that, in investment terms, ESG firms may enjoy lower discount rates. Of course, this is not saying that they grow profits faster but that ESG firms will tend to trade at a higher valuation, all else equal.
This is a positive for ESG firms, but importantly it is a benefit to investors only if they are holding ESG firms at the time that they are being re-rated to that lower discount rate. Basically, it is a one-time effect. If investors are going to pay a premium for ESG firms, it pays to be ahead of the curve and invest in them earlier. That dynamic may have already played out.
However, this does not mean that ESG firms deliver superior results, just that they are more attractive assets to investors. ESG firms are not necessarily better, just more sought-after in the stock market. They command a price premium, but not because of higher profitability or growth.
It does appear that a lot of claims are being made for the benefits of ESG investing that may not be firmly grounded. In part, this is because ESG a fairly recent trend, data is limited. Ideally, you want a few decades of data to really tease out drivers of stock-market performance in a way that holds up statistically. ESG simply hasn’t been around that long.
However, on current evidence some aspects of ESG investing may be over promising. It seems that there is stronger evidence that it is costly to be a bad firm that routinely flouts ESG guidelines and bears the costs of doing so. Still, the reverse may not be true. ESG stars may trade at a premium over time, but that doesn’t necessarily mean they will grow profits faster.
A lot of claims are being made for ESG investing. It may be simply be the right thing to do, and perhaps that’s sufficient justification for it. However, expecting an ESG orientation to lead to sustainably higher stock returns may be a stretch. Indeed, for any drop-dead simple investing rule, such as picking ESG stocks, to beat the financial markets over time may be a surprising outcome.
Still, it also appears that there is little suggestion that ESG investing is an inferior investing strategy, maybe the benefits of doing good should be enough.