In a recent research paper by Scientific Beta entitled, “Honey, I Shrunk the ESG Alpha”: Risk-Adjusting ESG Portfolio Returns, the answer is no.
The authors do admit that ESG strategies have outperformed on an absolute basis, but when adjusted for risk they are not generating any outperformance. They find that any absolute performance is generated from outsized exposure to the quality factor (Profitability, ROE, ROI, etc):
“75% of outperformance is due to quality factors that are mechanically constructed from balance sheet information.”
They also find that some outperformance comes purely from investor inflows into ESG:
“Recent strong performance of ESG strategies can be linked to an increase in investor attention. Flows into sustainable mutual funds show that attention to ESG has risen remarkably over the later period of our sample, from about 2013. We find that alpha estimated during low attention periods is up to four times lower than alpha during high attention periods. Therefore, studies that focus on the recent period tend to overestimate ESG returns.”
Finally, they conclude:
“We conclude that claims of positive alpha in popular industry publications are not valid because the analysis underlying these claims is flawed. Omitting necessary risk adjustments and selecting a recent period with upward attention shifts enables the documenting of outperformance where in reality there is none.”
I think they make some good points; I just think they are the wrong points. I also wonder if they really matter. As an individual investor, do you really care that your returns are coming from technology sector exposure and the quality factor? Probably not. As an institutional investor, maybe you are looking at Sharpe Ratio and Alpha, but as an individual, outperformance is outperformance. There are two questions, however, the paper does not address: how are ESG portfolios likely to perform going forward and are they really ESG?
ESG has generated relative outperformance by being out of value sectors and small caps, which have underperformed. Given nothing underperforms forever and markets go in cycles, what are the future implications of underweights to these areas? Time will tell. A bigger question is whether the stocks in ESG portfolios are really ESG. Can we label large cap technology and pharmaceutical companies ESG if they arrange their affairs to pay little taxes and use technology to displace workers? You could certainly make an argument that they are not.
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