Popular papers document positive alpha for equity strategies that favour ESG leaders, and asset managers readily adopt the idea of positive ESG alpha, viewing “ESG as a source of alpha that could lead to positive portfolio performance over time. […].”
In recent research conducted by Scientific Beta, we construct ESG strategies that have been shown to outperform in popular papers. We construct six different strategies in US equity markets and in developed markets outside the US. Each strategy goes long ESG leaders and short ESG laggards, using a different type of ESG score. The scores we use are the aggregate ESG rating, each of the three component ratings, the rating trend, and finally, a combination of ESG rating level and trend.
Our contribution is that we conduct a thorough risk adjustment when analysing the performance of these strategies. We assess performance benefits for investors when accounting for sector and factor exposures, downside risk, and attention shifts. These adjustments to performance are necessary to obtain a fair view of potential performance benefits for investors.
We first confirm that simple returns of ESG strategies may indeed look attractive, with annualised returns of up to 3 per cent per year. But even if ESG strategies have high returns, investors do not gain if these returns are due to sector biases or exposure to standard factors. The relevant question for investors is whether non-financial information in ESG scores offers additional performance benefits.
When accounting for sector biases and exposure to standard factors (size, value, momentum, low risk, and quality), none of the strategies we construct to tilt to ESG leaders adds significant outperformance, whether in the US or in developed markets outside the US. We find that 75 per cent of outperformance of ESG strategies is due to quality factors that are mechanically constructed from balance sheet information. ESG strategies in the US equity market also have a heavy tilt to the technology sector. After adjusting for such exposures, none of the strategies shows significant alpha. This implies that ESG ratings do not add value over information contained in sector classifications and factor attributes. Despite relying on analysis of non-financial information by hundreds of ESG analysts, ESG strategies perform like simple quality strategies constructed from accounting ratios.
We also extended the analysis in our paper to account for possible benefits in terms of downside risk reduction. The results show that ESG strategies do not offer significant downside risk protection. Accounting for exposure of the strategies to a downside risk factor does not alter the conclusion that there is no value-added beyond implicit exposure to standard factors such as quality.
Even if ESG strategies do not provide outperformance over an extended period, they may outperform in the short term. In particular, if attention to ESG shifts upwards, ESG strategies have positive short-term performance, but their long-term expected returns decline.
For investors, it is crucial to disentangle long-term returns from the effects of attention shifts. If upward attention shifts drive ESG returns over the recent period, returns of ESG strategies are inflated. Increasing attention raises demand for a firm’s shares, leading to higher prices. Investors need to deflate returns by subtracting the tailwind from rising attention to come up with realistic return expectations.
We assess the impact of attention shifts on ESG performance by distinguishing between time periods with high and low flows into sustainable funds. Outperformance during high attention periods is spectacular. Strategies based on overall ESG ratings show substantial outperformance of 4 per cent per year, relative to the market. However, outperformance shrinks to 1% when considering the low attention states, and disappears completely when adjusting for additional factors.
Investors need to be aware that alpha estimated during low attention periods is four times lower than alpha during high attention periods. While returns during high attention states may be relevant for investors who want to bet on rising future attention, returns during low attention periods provide a conservative estimate of long-term returns. Our analysis also reveals that attention shifts occurred over the later part of the sample period with a strong rise in attention since 2013 onwards. For this reason, studies that focus on the recent period tend to overestimate ESG returns. Investors need to be wary of analysis of ESG alpha that is limited to short periods which coincide with rising attention to ESG.
Overall, the effect of risk adjusting the performance of ESG strategies is clear-cut: the apparent alpha of ESG strategies shrinks to a level where none of the strategies delivers positive alpha.
Our study delivers important insights for investors. As a general matter, our analysis provides an example of how one can document outperformance where there is none: it is sufficient to omit necessary risk adjustments. Concerning ESG strategies, our findings question a widespread practice of using ESG as an alpha signal. They do not question the value-added of such strategies on other dimensions. 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.
Investors would benefit from further research on these important questions. A full copy of our paper can be found here: “Honey, I Shrunk the ESG Alpha”: Risk-Adjusting ESG Portfolio Returns, Scientific Beta Publication, April 2021.
Felix Goltz, PhD, Research Director, Scientific Beta