Honey, I Shrunk the ESG Alpha!A new study and subsequent survey results of market participants’ views on that study were conducted and provided by Scientific Beta. Access the full white paper here.
A survey conducted by Scientific Beta to collect market participants’ views on its recent white paper ‘“Honey, I Shrunk the ESG Alpha”: Risk-Adjusting ESG Portfolio Returns’ received responses from investment professionals with roles such as portfolio manager, chief investment officer, director of investment strategy research, head of asset allocation, head of ESG research, ESG analyst and research analyst. The respondents to this survey come from institutional investors, asset managers, banks, consultants and wealth managers managing assets worth USD3.3 trillion, USD645bn, USD4.1 trillion, USD179bn and USD7.7bn respectively.
The white paper questions the popular belief that ESG strategies generate outperformance and shows that the ESG alpha disappears when adjusting for industry and factor exposures. The results of the survey show that:
- Most of the respondents agree that there is no sound evidence that ESG strategies offer any incremental value in terms of performance, and that most of the performance is captured by style factors.
- Only 17% of respondents believe that the finding of absence of outperformance is surprising.
Dr Felix Goltz, co-author of the study and Research Director at Scientific Beta, said, “Our study of ESG performance comes to a clear conclusion: when using standard risk adjustments in performance measurement, widely cited findings on positive ESG alpha disappear. Irrespective of performance, however, a key driver of the adoption of ESG investing is that non-pecuniary and risk characteristics of their portfolios matter to investors. Rather than turning ESG investing in another hunting ground for alpha, asset managers should perhaps take such non-pecuniary and risk objectives seriously. Judging from our survey respondents, focusing on objectives other than alpha is a credible value proposition for ESG investing.”
Do Market Participants Consider that the Idea of Positive ESG Alpha Indeed Lacks Support?
Research indicates overall agreement with the main conclusion of the paper, that there is no solid evidence of positive alpha for the type of strategies analyzed. We find that two thirds of respondents agree with this conclusion while about one quarter are unsure. Only about one in 10 respondents disagree with the claim that there is no solid evidence supporting claims that ESG strategies generate positive alpha.
Of course, there might be very different reasons for readers to disagree with this conclusion, which is based on equity strategies constructed from commercial ESG ratings performance. Respondents may consider that these ESG scores do not reflect how investors should assess ESG criteria. Moreover, the study uses methods that are widespread in academic research and in investment practice to adjust performance for effects that can be explained by style factors and industries. Respondents may consider that such performance assessment methods, even though they constitute workhorses in empirical finance research and are widespread in industry practice, may not be relevant to them. There might also be other reasons for disagreeing. For example, respondents might have prior beliefs and the evidence presented in the paper may not be strong enough to lead to a substantial adjustment of these beliefs. Alternatively, respondents might consider other evidence that conflicts with findings in the paper. Overall, however, despite the limitations of the analysis in the paper, and despite the potential role of priors or other sources of evidence, two thirds of respondents voice agreement with the conclusion on the absence of alpha.
In addition to the headline conclusion, that there is no alpha, the Scientific Beta study showed that equity style factors and industries are the key drivers of ESG returns. In particular, most of the outperformance over the past decade of the ESG strategies we study can be linked to how these strategies tilt to equity styles (such as value, momentum and quality) or to industries (such as financials and technology).
Does the Absence of ESG Alpha Hold More Generally?
An important question one should ask when analyzing a sample is whether conducting additional robustness checks would alter the results. As Scientific Beta argues in the paper, we understand that our alphas, if anything, are overstated. They test a total number of 24 different strategies, resulting from different ways of constructing the ESG strategies. Testing such a large number of strategies creates a substantial risk of falsely discovering alpha in-sample, even if there is no true effect. We do not account for this risk since we compute statistical significance using standard methods that assume that we conduct a single test. Even though we set the bar too low, there is not one among the 24 strategies that shows significantly positive alpha after adjusting for risk. Accounting for multiple testing would lead to even less support for positive alpha.
Perhaps more importantly, one should consider plausibility of the results: Given what we know about the preferences investors have for ESG and financial characteristics of their portfolios, and about how assets are priced, should ESG strategies lead to positive alpha? Whether or not the empirical findings on the absence of ESG alpha is a surprise clearly depends on what the analysis of these economic mechanisms tells us.
We find that only about 17% of respondents consider that absence of positive alpha is a surprise.
In the paper, Scientific Beta argues indeed that the findings are not surprising. Instead, they’re finding that there isn’t any positive alpha appears highly plausible when considering the economic mechanisms driving investment performance. In somewhat competitive financial markets, investors do not easily gain an information advantage. Even if ESG leaders show better corporate financial performance, this does not increase their expected returns if investors know about this relationship (Bebchuk, Cohen and Wang, 2013). In such markets, investors face trade-offs. Theory suggests that investors forego returns by tilting to ESG leaders because they receive other benefits. Investing in ESG leaders offers non-pecuniary benefits, such as aligning investments with norms (Pastor, Stambaugh and Taylor, 2020), and may allow hedging certain types of risks, such as litigation or climate risk. Such benefits offset lower expected returns.
What Benefits Should Investors Look Out for when Considering ESG Strategies?
Given that claims about positive ESG alpha may be greatly exaggerated, investors may ask why they should consider ESG investment strategies. The Scientific Beta study emphasizes that absence of alpha is not a thumbs down for ESG strategies. Instead, the study gives the thumbs down for a practice which consists of documenting outperformance where there is none by omitting necessary risk adjustments.
Concerning ESG strategies, the study’s findings question the widespread practice of using ESG as an alpha signal. However, they do not question the value-added of such strategies on other dimensions. They argue that investors should ask how ESG strategies can help them to achieve objectives other than alpha, such as aligning investments with their values and norms, making a positive social impact, and reducing climate or litigation risk. They argue that investors would benefit from further research on these important questions.
Scientific Beta’s study of ESG performance comes to a clear conclusion: When using standard risk adjustments in performance measurement, widely cited findings on positive ESG alpha disappear. Such a clear conclusion however will not, and is not meant to, close the case. There will always be debate over investment performance. Models that separate abnormal performance (or alpha) from normal performance (or beta) are imperfect. Economic models that establish the mechanisms of outperformance necessarily rely on assumptions. However, it does currently appear that the case for positive ESG alpha seems weak compared with other, better-established ways of generating outperformance.
Irrespective of performance, a key driver of the adoption of ESG investing is that non-pecuniary and risk characteristics of their portfolios matter to investors. Rather than turning ESG investing in another hunting ground for alpha, asset managers should perhaps take such non-pecuniary and risk objectives seriously. Judging from the survey respondents, focusing on objectives other than alpha is a credible value proposition for ESG investing.