A new study has debunked claims environmental, social and governance (ESG) investing provides either market ‘alpha’ or downside protection in its own right.
The just-published analysis by research firm Scientific Beta also suggests the recent surge of money into ESG funds could lower longer term return prospects for the strategies.
According to the ‘Honey, I shrunk the ESG alpha’ report, none of the 12 strategies examined in the study outperformed after accounting for underlying factor biases.
The paper says about 75 per cent of claimed ESG alpha can be attributed to a ‘quality’ factor tilt alone.
Furthermore, the report – authored by Scientific Beta analysts Giovanni Bruno, Mikheil Esakia and Felix Goltz – found that increased flows into ESG strategies since 2013 skewed performance upwards.
“We conclude that claims of positive alpha in popular industry publications are not valid because the analysis underlying these claims is flawed,” the paper says. “Omitting necessary risk adjustments and selecting a recent period with upward attention shifts enables the documenting of outperformance where in reality there is none.”
While the flood of money into ESG funds over the short-term has boosted returns in a positive feedback effect that lifts the prices of underlying securities, investors should brace for a trend reversal ahead.
“In other words, not only will ESG strategy returns go back to their initial long-term average after a period of tailwind from upward attention shifts, but they will now deliver a lower long-term average return,” the Scientific Beta report says.
The study also found ESG strategies have not provided protection against market downturns during the period under review (2007 to 2020) after stripping out factor influences.
“We conclude that information in ESG ratings does not provide downside protection beyond what is available from information in stock returns and accounting ratios that are used to construct equity style factors,” the paper says.
The study analysed 12 portfolios based on popular ESG strategies over January 2007 to June 2020 to test whether the style delivers outperformance “by favouring ESG leaders”.
“ESG is often perceived as a source of outperformance and ESG providers are fond of endorsing this perception,” the report says.
But the study says investors have flocked to ESG for other reasons such as aligning portfolios with “values and norms”, driving better corporate behaviour and countering longer-term risks like climate change.
“Our findings do not question that ESG strategies can offer substantial value to investors,” the report says. “Instead, they suggest that investors who look for value-added through outperformance are looking in the wrong place. It might be time to consider ESG strategies for the unique benefits that they can provide, such as hedging climate or litigation risk, aligning investments with norms, and making a positive impact for society.”
Scientific Beta, a research house and factor index provider, is part of the French EDHEC Risk Institute.