ESG and alpha

Academics collide on the relationship between environmental, social and corporate governance (ESG), and alpha. One view is there is a clear link that can be uncovered by a deep dive into the underlying factors using a sophisticated operating engine. The other perspective is that the market will price in environmental and social factors, the way it has done with governance. Amanda White speaks to academics with different points of view.

Andreas Hoepner, lecturer in banking and finance at the University of St Andrews in Scotland, says alpha requires a sophisticated investment operating engine to find ESG.

The simple step of taking the ESG data, especially if it is sold to everyone, is usually not adequate to find alpha, he says. But if extra steps are built in, then alpha becomes evident.

“The extra steps are, for example, to look at industry or other types of classifications. ESG factors have a profoundly varying impact on firms, depending on their business model. Environmental management, for instance, has a very different meaning for banks than for oil companies. When you start to build extra steps, you quickly come to some alphas.”

The more competition in the area, according to Hoepner, the higher the level of operating engine needed to identify alpha.

“For example, analysing conventional fundamental accounting information, there is a lot of competition so the engine needs to be highly sophisticated,” he says, referring to the level of information portfolio managers assess in order to find alpha.

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Within the field of ESG, Hoepner thinks there isn’t as much need for an engine that is quite as complicated, because there is not as much competition.

“From an investor point of view, when searching for alpha, ESG is a style similar to value investing: you are convinced of a certain type of asset and try to understand where and when it performs best. In the value-investing case, you are convinced by firms with low price-to-book rations, while in the ESG-investing case, you are convinced of firms with more sustainable business processes and a longer term management perspective,” he says. “From an investment-style perspective, at St Andrews we are optimistic that ESG information is not fully efficient as in our research we find many alpha opportunities that cannot be fully explained by transaction costs.”


When it comes to the relationship between ESG and alpha, Hoepner highlights the impact of specialist skills, pointing to the 2010 Journal of Business Ethics paper, The performance of socially responsible mutual funds: the role of fees and management companies by Javier Gil-Bazo, Pablo Ruiz-Verdu and Andre Santos.

The study found that in the period from 1997 to 2005, US socially responsible investing (SRI) funds had better before-fee and after-fee performance than conventional funds with similar characteristics, and the differences were driven exclusively by SRI funds run by managers who specialised in SRI.

Further, funds run by companies not specialised in SRI underperformed their matched conventional funds.

“The research found some very interesting outcomes. Specialist funds are clearly better than conventional funds, and non-specialist are worse than conventional funds,” he says.

Hoepner says this highlights a key failing of current investment thinking in that there is a clear mismatch between ESG skill and finance training.

This is also something that asset owners are discovering in their own approach to ESG integration.


The CalPERS case
The investment office of CalPERS, for instance, now has set implementing ESG as a strategic goal and its board is committed to this.

But Anne Simpson, director of corporate governance at CalPERS, recently said that it won’t work unless it can get the F – as in finance – into ESG.

Hoepner believes there are inadequacies in using only financial accounting data in financial analysis, as corporate accounts are conceptually an estimation and they are more relevant in the valuation of some companies, such as Fedex, than other companies that trade at large multiples of their book value, such as Amazon.

He believes it is also important to assess non-tangible factors, such as management quality, and this is an opportunity for assessing whether alpha exists.

“There is an enormous opportunity to incorporate intangible factors in a responsible way in financial markets,” he says. “You speak to people in other industries such as engineers or computer scientists and they say it is obvious that intangible factors affect consumer decision making and so performance. Just financial economists have possibly believed their own theories of the hyper-rational homo economicus in the consumer and also the analyst a little too much.

“We are very optimistic ESG alpha exists, but you can’t get ESG from one nice, level approach. But if you combine ESG metrics with very sharp statistics you can find alpha.”

One of the faults, according to Hoepner, is that analysts either look at financials and then ESG, or ESG and then financials.

“I think there’s way too little of both together. If you focus on one, then you miss the other. Bringing the two drivers together can be powerful,” he says.

“It is important to compare ESG investment to other styles when you want to do financial analysis, otherwise it is treated like a step child.”

Hoepner points out that when it comes to portfolio and strategic decisions, there is more to it than just alpha – client loyalty and the universal owner hypothesis come into play, and trust becomes very important.


What is relevant will be priced
Unlike Hoepner, Rob Bauer, professor of finance at Maastricht University School of Business and Economics and director of the European Centre for Corporate Engagement, thinks that markets have already priced in some of the relevant ESG information.

“By simply buying good ESG companies, you do not necessarily make good returns in the long run,” he says. “Especially, information on G (governance) is properly priced to a large extent. It might not be at that stage yet for E and S, but I strongly believe that market participants are gradually pricing the relevant information pieces, and they certainly will in the next decade. So there will be no information advantage.”

Bauer points to the study by Harvard academics, Lucian Bebchuk, Alma Cohen and Charles Wang: Learning and the disappearing association between governance and returns.

The study looks at the relationship between returns and a governance index, constructed on the basis of 24 governance provisions that weaken shareholder rights. During the 1990s there was a clear governance-returns correlation, which then disappeared in subsequent years.

The paper provides evidence that the existence and disappearance of that correlation were due to market participants’ learning to appreciate the difference between well and poorly governed firms.

It found that the disappearance of the governance-return correlation was associated with an increase in the attention to governance by a wide range of market participants; and until the beginning of the 2000s, but not subsequently, stock-market reactions to earning announcements reflected the markets being more positively surprised by the earning announcements of good-governance firms than by those of poor-governance firms.

“The Bebchuk study confirmed the results of the Paul Gompers study in 2003, which found that in the 1990s well governed firms performed better than poorly governed firms. The Bebchuk team redid that report and now finds that good governance (especially information on takeover defences) is fully priced into stocks.

Probably, the same will happen with E and S, but it will take some time to figure out which information is relevant for cash flows and the volatility of cash flows of firms,” Bauer says. “I think it is not clear yet, but it is becoming clearer. In the end, what is relevant will be priced; what’s not relevant is simply not relevant.”


Engagement also starts with E
Bauer believes engagement is the only sustainable way of responsible investing.

“There is a need for a collaborative investor community to engage and change practice on relevant issues in both the financial dimension and the ESG dimension. This will then change the valuation of these companies and lead to higher returns.

Both Bauer and Hoepner are previous winners of the French Responsible Investment Forum, which supports promising research and significant academic achievements and is endorsed by PRI.

Jean-Philippe Desmartin, who created the awards in 2004 and who is the head of ESG research at Oddo Securities, says ESG research is scant.

The awards aim to promote in the long-term academic research with finance and ESG in Europe, he explains.

The genesis of the award came in September 2003, when he saw Harvard’s Michael Porter speak at Copenhagen Business School and identify ESG as a key subject for companies.

“He said it was a top-10 issue for the following decade… and there needed to be more professionalism, to deliver academic research not just to show convictions.”

Desmartin believes that in practice integrating ESG is not completely different from other fundamental analysis.

“Analysts want to understand management, products and services as well as financial statements and fundamentals,” he says. “At Oddo, we are convinced from ESG research you can get alpha.”

There are a number of awards, and this year the winners will be announced at the PIR-CBERN Academic Conference 2012, Evolution of Responsible Investment: Navigating Complexity, to be held from October 1 to 3 at York University in Toronto.

    Thomas Gillespie

    I perceive a couple of issues with the vast bulk of ESG research:
    1) Most of the research misses the main point of ESG in that it is a risk mitigation exercise and so the chief question needs to be “Do ESG/SRI finds have a lower core/tail risk than benchmark or comparable funds?”
    2) Good ESG stocks have value and size style biases which tend to dominate. Particularly strong G stocks and to a lesser extent strong S and E stocks. Good E stocks have a significant sector bias that at least some vendors strip out when rating the stocks. These biases tend to dominate returns when trying to answer the question “How much does the ESG rating differentiate stock performance over and above the sector, value and size biases?” Happily this is not the case with the Bebchuk, Cohen & Wang paper.
    The comments of Ms Simpson from CALPERS address the perspective of most institutional investors other than those with an overarching SRI/ESG mandate – ESG should be part of good investment management, but only a part. Now it is up to the academics to show the risk impact.

      Andreas Hoepner

      Hi Thomas, here tentative replies to your two questions:
      1) ESG stocks tends to have lower and tail specific risk (see the working papers of Kais Bouslah, or also Daniel Hann’s PhD or the Financial Review paper of Darren Lee)
      2) Any decent academic study should control for investment style biases. Even more so, cutting edge studies would control for investment styles at different geographical levels (e.g. if US value stocks are performing well at any point in time, this does not automatically also mean that value stocks are performing well globally).

    Duncan Paterson

    Mathew – happy to have a look at proposals – we’ve got an ESG service for govt bonds going back over 5 years:

    Andreas Hoepner

    Mathew, you might want to check the development of ESG sovereign rating and conventional sovereign credit ratings over the last decade. You will probably like it … 😉 …

    Academic research in Business/Economics, unfortunately, takes 2-4 years to formally publish in peer reviewed journal and working paper platforms such as SSRN as used by academics to different degrees. So when you are expecting some research to exist but cannot find it, maybe drop an academic or the PRI Academic Network an email and there might be insights …

    [Amanda: Thanks, very nice article!]

    Mathew McCrum

    I am amazed that there hasnt been more research in ESG for government bonds. To me it makes more sense ESG investing in bonds that equities………….

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