The question of whether stocks with high environmental, social, and governance (ESG) ratings hurt performance has been the center of debate in the investment community for some time now. A new study provides some clues, at least if you believe that “skin in the game” is an indicator of a manager’s confidence in their strategy’s returns. Managers who invest their own money in the broad-based stock mutual funds they run — not those that are specifically focused on ESG — believe that these stocks will hurt their returns.
According to a recent paper published by the Swiss Finance Institute, funds in which managers have skin in the game — that is, funds run by managers who are considered to be what the study calls “co-investors” because they’ve invested their own money in the fund — tend to have a significantly lower proportion of highly rated ESG stocks than peers. That suggests that these managers don’t believe these stocks will deliver superior returns.
In addition, the paper also found that co-investing managers tend to overweight stocks that rate poorly on ESG measures.
“Overall, our analysis indicates that fund managers do not expect ESG strategies to deliver higher risk-adjusted performance,” the paper said. “This suggests that the popularity of these strategies in the mutual fund industry is primarily driven by client demand — that is, by the possibility [that] fund managers [can] attract higher flows by tilting their portfolios in a higher-ESG direction.”
The authors further confirmed the theory by analyzing how managers are compensated. “[For managers] whose compensation is tied to flows, what we find is that they invest more in high-ESG stocks,” Vitaly Orlov, one of the paper’s three authors, told II in an interview. “However, when these portfolio managers start to co-invest in their own funds, their overexposure to ESG almost completely reverses.”
Orlov and his colleagues based the result on a study of 1,273 U.S. funds actively managed by 2,616 unique managers from January 2015 to December 2020. The study only looked at broadly diversified equity funds — in other words, those in which the manager can decide whether or not to invest in ESG stocks — rather than those with an explicit ESG mandate.
They analyzed managerial ownership by looking at a fund’s Statement of Additional Information, an annual filing that contains data about the ownership stakes of portfolio managers. About 77 percent of the funds have co-investments from managers; the average stake is $802,208, according to the paper.
“Our results do not say that ESG factors are not important or necessarily unrelated to future financial performance,” Stefano Ramelli, another author of the report, told II. “What they suggest is that apparently, fund managers, on average, don’t believe that to be the case, despite a widespread narrative in the industry suggesting otherwise. But their beliefs may also turn out to be wrong, of course.”
Shivaram Rajgopal, a professor at Columbia University who has conducted numerous research studies on ESG-related topics, said he isn’t surprised by the finding, because it’s generally hard to integrate the interests of investors and managers in ESG.
But Rajgopal is surprised at how much money portfolio managers have in their own funds. He stressed that it is possible that these managers could have gotten their shares through an employee stock ownership program, in which the shares were discounted or completely free as a stock grant. That makes him skeptical about the study’s results. In that case, it would be hard to associate managerial ownership with the true opinion that these managers have of ESG, he said.
