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Dissecting a company’s quarterly earnings report, digging into business models, and looking for signs of mispricing: for most value investors it’s their bread and butter. In a world plagued by insider scandals, climate change warnings, and brazen CEOs, interest is surging in a new potential source of value – environmental, social, and governance (ESG) investing. Europe alone has some $12tn committed to sustainable investing and there has been a 70% growth in smart beta ESG assets under management. Governments can more easily hit their environmental targets, pension funds have new outlets for their cash, and activists are happy – what’s not to like?
It is still unclear, however, how investors best incorporate ESG into their portfolio – and more importantly, does it help or hurt performance? A recent paper by Lasse Heje Pedersen, Shaun Fitzgibbons, and Lukasz Pomorski of AQR Capital Management attempts to conceptualise and quantify the costs and benefits of ESG investing.
How to Measure ESG?
The researchers identify four proxies by which a stock is considered ethical. They avoid claiming which proxy is better or worse but test each one.
1. Accruals – a measure of governance. Better governed companies tend to have lower accruals, indicating a firm’s conservative stance on accounting.
2. MSCI ESG – a very widely used measure of ESG, computed by MSCI.
3. Carbon intensity – measures how ‘green’ a company is as a ratio between carbon emissions as a proportion of revenues.
4. Non-sin stocks – a scale of how ‘bad’ a stock is, with the worst operating in the gambling, tobacco, and alcoholic beverage space.
Do Investors Care?
It seems so. All four ESG proxies matter to portfolio managers when they form their investments – at least judging by percentage of holdings in ESG stocks, trading activity, and order flow. This is especially the case for accruals.
Should Investors Simply Screen Out ‘Sin’ Stocks?
A number of funds decide simply to exclude stocks with very low ESG scores as a strategy. However, unsurprisingly, such screening reduces expected performance, lowering the maximum achievable risk-adjusted returns. This is likely because those ‘sin’ stocks can effectively be used as funding sources by allowing investors to short them to fund long positions in ‘good’ stocks.
Does High ESG Mean Better Future Stock Fundamentals?
The researchers define future fundamentals as the return on net operating assets as well as gross profitability over assets. They find that firms with low accruals see higher return on assets and profitability over the subsequent fiscal year. Thus, it’s possible that accruals, a measure of ESG, contain information about future fundamentals that may not be fully priced in by the market. Interestingly, stocks with low accruals also trade quite cheaply or i.e. are undervalued.
MSCI ESG data and non-sin stocks both correlate with higher profitability but not return on assets. Low carbon footprint correlates with higher return on assets but not gross profitability. Sin-stocks have a weak link to fundamentals overall.
Will Investing in ‘Good’ Stocks Yield Returns?
Somewhat. This was the weakest part of the empirical analysis and calls for further research. Nevertheless, the strongest relationship was observed between accruals and future returns. Next up was the so-called Sin premium, which finds that sin stocks have higher expected returns. However, the higher returns disappear when other factors such as momentum are included. Overall, there appears to be some information gaps in ESG not yet priced by the markets.
The Bottom Line – to ESG or not to ESG?
It’s complicated. In developing the model, Pedersen, Fitzgibbons, and Pomorski discovered that while some ESG measures predict higher returns, others lead to worse performance. And still others have a seemingly negligible impact on the portfolio. Overall, the impact of ESG on investment performance seems dependent on how much the market at large utilizes ESG information. When most investors ignore moral considerations, ESG is a source of alpha. But as more investors utilise it, that alpha diminishes.
While there has been a surge in the number of funds that have explicit ESG objectives, we increasingly see funds which are not mandated to follow a responsible process and yet are nonetheless integrating ESG. This is usually used as a hygiene factor in recognition of the positive impact it can have on corporate performance and risk mitigation. This paper, while not exhaustive, is a considerable extension of the evidence on ESG so far and a pioneer in a growing discussion.
Presiyana Karastoyanova is a Research Analyst at Macro Hive. Presiyana has previously worked at Nomura & Goldman Sachs, and has attained an MSc in Finance from Imperial College Business School.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)