ESG and Alpha: Sales or Substance?

Illustration by II

Illustration by II

Managers of ESG investments create false hope, oversell outperformance, and contribute to the delay of long-past-due regulatory action.

In late 2018, while seated on the dais of The New York Times DealBook Conference, BlackRock CEO Larry Fink declared that “demand for ESG [environmental, social, and governance] is going to transform all investing.” At the time, Fink’s assertion seemed bold. Today it looks prescient. Escalating social and environmental challenges and claims that ESG investing can deliver alpha (outsize market returns) and a more sustainable planet have prompted investors to divert more than $3 billion per day to ESG investment products. According to Bloomberg, ESG investment now represents approximately one third of all professionally managed assets.

This article sets aside the question of the social and environmental impact of ESG investing to examine claims that ESG funds deliver alpha. To better understand how ESG investing might lead to outsize returns, we conducted a series of confidential interviews with industry practitioners. We then reviewed the empirical research that these same ESG professionals most cited. The upshot: We learned that the logic and evidence for assurances of ESG-driven alpha are lacking. Indeed, it is our best guess that flows of money into ESG funds represent a marketing-induced trend that will neither benefit the planet nor provide investors with higher returns — but might defer needed government regulation.

What Constitutes ESG Investing?

ESG investing is not precisely defined. One interviewee described ESG investing as “diverse, growing, and hard to categorize.” Funds focused on diversity, resource scarcity, climate tech, and women’s empowerment could all be classified as ESG investments. So too both active and passive funds. Nonetheless, analysts typically group ESG investment strategies into one of five categories: impact (seeking environmental or social outcomes and most often undertaken by private investors), thematic (focusing on a theme such as water scarcity or energy transition), engagement (direct communications between investors and companies), negative screen (excluding certain industries), or integration (considering ESG-related risks and opportunities).

First branded socially responsible investing (SRI), ESG strategies date back 50 years. In the 1970s, investors, including some faith-based institutions, sought to invest in a way that was consistent with their values, and funds were created to fill this demand. These funds exclude companies whose activities investors deemed immoral — such as support for apartheid in South Africa, the sale of tobacco products, or the production of nuclear weapons.

In the 1990s, a new “positive” theory of responsible investing emerged. Its advocates, including one of the authors of this article, argued that a company’s social or environmental performance could provide hidden information about future profits, and thus could help investors select stocks with higher returns. Uncovering the information needed for such investing required direct and intensive engagement between fund managers and corporate executives, so fund offerings with such “deep green” (high-engagement) strategies were limited largely to boutique asset-management firms such as Domini Impact Investments and Trillium Asset Management.

New modes of ESG investing appeared during the 2000s — such as funds directed toward innovation in low-carbon technology or the protection of natural resources — but today’s most popular approach, “light green” ESG investing, did not take off until the 2010s. Like the deep-green funds of the 1990s, these new investment vehicles were based on the premise that ESG data could enable portfolio managers to pick stocks with higher future returns. Unlike earlier approaches, new light-green strategies used computer algorithms and commercially available ESG rankings to select stocks. This more automated approach allowed a wider variety of fund types to claim that they incorporated ESG data and enabled the asset class to scale quickly.

The opportunity to generate alpha with lower beta and planetary impact has proven to be an extremely effective way to market funds. In the past two years, inflows to light-green ESG funds have been almost twice those of the rest of the stock universe combined. To get in on the boom, asset managers have increased the number of ESG funds by five times over the past decade, according to Morningstar, and aggressively “repurpose[d] and rebrand[ed] conventional products into sustainable offerings.”

Today’s varied ESG investment vehicles can be actively or passively managed, and might focus on one or more E, S, or G characteristic, such as gender diversity, carbon emissions, governance criteria, or resource intensity. Funds might also combine a traditional form of investing, such as growth or value, with a specific ESG focus. Notwithstanding the differences in stated approaches, many ESG funds end up with similar holdings (see below for a representative sample of ESG funds).

What Are the Cracks in Practitioners’ Arguments for ESG Alpha?

BlackRock’s October 2021 research report entitled “Seeking Outperformance Through Sustainable Insights” asserts that “investors can use systematic and fundamental [ESG] approaches to generate excess returns.” To better understand the rationale and evidence backing light-green ESG fund claims of alpha, we interviewed more than a dozen current or former ESG portfolio managers, institutional investors, or analysts in the space. The professionals made four main claims about ESG performance: It produces higher profits, signals higher stock returns, lowers capital costs, and attracts investment flows.

Below we discuss the rationales provided by ESG investment practitioners and assess each theory’s logical validity.

Delivers higher profits: Most interviewees noted that corporations with higher ESG performance tend to deliver higher profits. The mechanisms they proposed varied, but commonly they contended that companies with green attributes (for example, good governance or a progressive approach to human capital) could attract and retain high-caliber employees. Several portfolio managers also noted that companies with high ESG scores are more eco-efficient and thus generate better gross margins, while others argued that consumers are willing to pay more for, or switch to, more sustainable products, thereby enabling high-ESG companies to grow revenue and take market share from peers.

  • Logic problem: Higher profits alone do not necessarily lead to excess returns if the stock price already includes expectations of these profits. As New York University finance professor Aswath Damodaran notes, “investing in a well-managed company or one that has high growth does not translate into excess returns if the market already is pricing in the management and growth.” In other words, for managers to create a portfolio that will generate alpha, they must have information that the future returns of companies will be higher than commonly believed.

Signals higher future stock returns: Private information about a company can provide an investment edge. If ESG data provide fund managers with information that is otherwise difficult to obtain, it could lead to an advantage when selecting investments. In the case of light-green funds, most ESG data comes from commercial providers of ESG data, including MSCI, Sustainalytics (owned by Morningstar), and Refinitiv. These providers use historical information, most of it from public sources, to create measures of corporate vulnerability to E, S, or G factors.

  • Logic problem: Fund managers themselves noted one of the biggest problems with this approach: ESG data are widely available, making it difficult for any single investment fund to obtain a competitive edge using the data alone. In addition, many sources have called into question the quality of ESG data. It is possible that ESG fund managers have developed proprietary algorithms for processing the data to identify investment opportunities, but initial work using machine learning to identify predictive elements in one popular source of ESG data found no reliable patterns.

Lowers the cost of capital: Several ESG fund managers asserted that highly rated ESG companies are better managers of operational, regulatory, and reputational risks. Such companies might use climate modeling tools for plant location choices, better prepare for pending regulation, or reduce their supply chain risks. As a result, according to investment practitioners, such companies will logically be accorded a lower cost of capital, thereby raising their valuation.

  • Logic problem: One of the authors of this article worked as the COO for an early ESG pioneer, Timberland, and agrees that high-ESG companies are likely better managers of risk. Timberland, for example, shared the names and addresses of all its sourced factory partners and used third-party auditors to report on factory code-of-conduct compliance. The company reported on its ESG — then called corporate social responsibility, or CSR — practices quarterly to its investor base. However, once better risk management is recognized and absorbed into stock prices or the cost of debt, it should not have any further effect on stock returns.

    In addition, according to finance scholars, the argument that lower cost of capital leads to higher returns requires backward logic. If investors provide a firm with capital below its fair-market price, they will receive a lower, not higher, future return — the opposite of what promoters of ESG investing promise. Indeed, according to University of Chicago finance professor and Nobel laureate Eugene Fama, co-architect of the Fama-French method for portfolio analysis, “lower costs of capital for E&S [environmental and social] accredited firms mean for E&S investors, virtue is its own reward since investors get lower expected returns.”

Benefits from capital flows: Some fund managers argued that the flow of investment capital itself could cause higher returns. Over the past three years, $20 trillion has flowed to ESG assets. These flows increase demand for highly rated ESG companies, thereby raising asset prices. In July, Karen Karniol-Tambour, co-chief investment officer for sustainability at hedge fund Bridgewater Associates, said, “We suspect that large ESG flows are still ahead of us.” She expected that “investors shifting to more focused portfolios of sustainable companies” would increase “relative stock prices.”

  • Logic problem: There is little reason to doubt that money flowing into investments can increase prices for a time, thereby allowing early investors to accrue higher returns. Sometimes the rising prices can in turn give a veneer of authenticity to the investment strategy. Stock bubbles are formed in this way, and one could easily see this happening with ESG investing. According to Brent Goldfarb, professor of management and entrepreneurship at the University of Maryland, market bubbles often continue until some contrary evidence reverses the feedback process. Then, fear of losses causes more selling and drives prices lower. At the same time, research has shown that increasing the supply of capital to sustainable companies will push up their stock prices and lower their future returns, not the opposite.

Notwithstanding the enthusiasm for ESG investing and the consequential fund flows to the category, not all ESG managers and analysts are sold on the connection between ESG and alpha. For example, in a February 2021 conference call, DWS Group chief investment officer Stefan Kreuzkamp noted that many fund managers at the firm were doubtful about ESG investing. Interestingly, this skepticism was shared by every former asset management professional we interviewed.

How to check news that looks too good to be true

When appropriate, we asked interviewees to cite empirical evidence to support their contentions. The most frequently cited study was a 2016 publication by Mozaffar Khan, George Serafeim, and Aaron Yoon, “Corporate Sustainability: First Evidence on Materiality.” In this study, the researchers evaluated the connection between material ESG factors and stock performance. They used criteria from the Sustainability Accounting Standards Board to select which attributes of ESG performance were material for each industry, and then formed these attributes into corporate scales. They found that the top 20 percent of firms, as scored in this manner, experienced 300- to 600-basis-point higher returns from 1991 to 2016 — an astonishingly large and extended effect!

This study has had broad influence. For example, in 2019, John Streur, CEO of Calvert Research and Management, a subsidiary of Eaton Vance Corp., which was acquired by Morgan Stanley last year, credited the study for affirming his belief in ESG investing. According to Streur:

Calvert partnered with professor George Serafeim at Harvard University to conduct research on this topic. Among other findings, we learned that firms in the top quintile of performance on financially material ESG issues significantly outperformed those in the bottom quintile. If an investor had invested $10,000 in 1993 in a portfolio of stocks performing in the top quintile on relevant ESG factors, by 2014 that portfolio would have returned more than twice that of a portfolio of stocks performing in the bottom quintile on financially material ESG factors.

News this good begs to be checked, and one of the authors of this article, Andrew King, recently completed a study that did just that. In research co-authored with Luca Berchicci, associate professor at the Rotterdam School of Management, he found that the original database contained a hidden weakness: In each year, approximately 75 percent of the firms had unchanged material ESG scores, making it difficult to select a portfolio of firms with improved scores. To get around this deficit, the original authors used a regression to rescale the scores, but this process led to an ironic outcome: Firms in the dirtiest industries tended to be rated as more sustainable. When King and Berchicci corrected this error, evidence for a link between ESG and stock returns vanished. They then used alternative models and machine learning to search for a reliable correlation. Based on their analysis, they concluded that the original estimate was a “statistical artifact” and that one set of ESG data is likely to be of little value in predicting stock returns.

Several interviewees also mentioned meta-studies that have synthesized the results of many empirical studies. Last year, NYU Stern School of Business and Rockefeller Asset Management published findings from their review of the results from 1,000 studies. According to professor Tensie Whelan, a co-author of the study, almost 60 percent of the studies showed that investments in ESG funds “operated at par [with conventional funds] or generated alpha.”

We cannot review those 1,000 studies here, nor can we evaluate the many meta-analyses that have reported a range of results. However, it is revelatory that University of Warsaw professor Marc Orlitzky, author of one of the most cited meta-analysis of ESG investing, has recently disavowed the use of the approach, arguing that the different measures and methods used by scholars make it impossible to form a meaningful synthesis. Even Serafeim, an author of the aforementioned “Materiality” study, remarked that research has failed to find evidence of a connection between ESG and financial returns. He noted that “despite countless studies, there has never been conclusive evidence that socially responsible screens deliver alpha.”

Finally, a number of portfolio managers cited internal studies that back-tested particular ESG strategies. These are, however, hard to replicate. Given the trillions of dollars invested in ESG funds, why didn’t, or couldn’t, portfolio managers point to more solid empirical evidence? We conjecture that the nature of ESG investing makes empirical research difficult, and we suspect that this will likely impede consensus for some time for the following reasons.

Not well defined: First, there is no standard definition of what constitutes good ESG. As a result, studies and funds deliver mixed results depending on how each defines ESG. While the “Materiality” study examined the relationship between changes in ESG and stock performance within the same firms, other studies have chosen to compare the equity performance between firms. Studies have defined ESG by using measures including rankings from ratings services, employee happiness, carbon emissions, lawsuits incurred, and waste generation. At the same time, the absence of both regulation of ESG ratings and the auditing of corporate ESG reports leads to fundwashing (like greenwashing of products) tainting the utility, consistency, and validity of the research.

Based on noisy measures: ESG ratings firms’ assessments are based on subjective judgments, extrapolation, and incomplete data. According to one interviewee, the data are also often “old, self-reported, and unaudited.” A recent study found that more than half of disagreements are based on factual discrepancies, with the rest attributable to differences in the scope of ratings and the selection of different weights in the formation of aggregate scales. They also discovered the existence of a house effect, where each rater’s overall opinion of a firm influenced its measurement of specific categories. Corroborating their result, a Wall Street Journal report found that ratings vary wildly: one third of the ratings of three leading firms agreed, one third disagreed, and the remaining third were “opposite.” Finally, a recent study determined that previous ratings are sometimes backdated to better fit subsequent performance.

Based on flawed research: Many of the studies that report ESG outperformance are flawed and are based on short time horizons that are not statistically significant. According to Alex Edmans, professor of finance at London Business School, “Omitting necessary risk adjustments and selecting a recent period with upward attention shifts enables the documenting of outperformance where in reality there is none.” Research Affiliates, a leader in smart beta and asset allocation, considered four broad ESG-themed strategies (exclusionary screening, ESG integration, green revenues, and impact investing) to determine if they could find a relationship between ESG and alpha. Once they made the appropriate risk adjustments, they concluded that “ESG is not an equity return factor in the traditional, academic sense.”

Suffers from causal ambiguity: Finally, a positive relationship between high-ESG companies and alpha may result from correlation — not causation. Because valuation depends on many factors, it is impossible to ascribe financial performance to any single factor, such as ESG. It may, for example, be that both ESG and equity returns are a function of the quality of management. As NYU Stern School of Business finance professor Aswath Damodaran notes, “almost every study that purports to find positive correlation between profitability and ESG scores trips up on the causality question, i.e., are ‘good’ companies more profitable or are companies that are more profitable able to take the actions that make them look good?”

Can ESG Investing Deliver Alpha?

Many light-green investment strategies don’t even seem to be trying to deliver alpha. They are little more than market portfolios branded with different names. As but one example, the three-year-old Vanguard ESG U.S. Stock ETF has a 0.9974 correlation to the S&P 500. A correlation of 1 would mean that the funds are perfectly in sync. It is hard to imagine how such funds could consistently outperform the market.

That said, it is certainly possible that some ESG investment strategies may generate alpha. For example, although it is employed less frequently than negative screening or ESG integration, engagement seems to be a promising path to outperform the market. A study of engagement titled “Coordinated Engagements” looked at 613 public companies that were the target of activist investors focused on improving ESG practices. It found “positive excess returns” in the 18 percent of engagements where the activism succeeded. Ironically, this is the same type of investing first employed by the positive-screen funds, those that invested only in socially responsible firms, 20 years ago. Another ESG strategy that might deliver alpha is investing early in companies that are poor ESG companies but are on a path to improvement. Studies by Rockefeller Capital Management and Bernstein found the best ESG “improvers” outperformed the worst group of ESG “decliners” over the ten-year period from 2010 to 2020.

Finally, fundamental analysis aimed at finding companies that stand to gain from an intensification of environmental regulatory pressure or a shift in consumer behavior has also proven, in some cases, to be a winning formula. This is the thesis underlying the growing sums being invested in climate-tech solutions and several thematic ESG funds.

Why It Matters

Trillions of dollars are now invested in light-green ESG funds, and there is little evidence that they will deliver planetary impact or the promised higher returns. What harm will this do?

For starters, capital is being transferred to asset managers for ESG. According to FactSet, light-green ESG funds carry fees that are often more than 40 percent higher than fees for traditional comparable funds. At the same time, asset managers, ESG ratings firms, consulting firms, investment banks, and accounting firms are capitalizing on the mania. As but one example, PwC just announced that it is hiring 100,000 new professionals over the next five years, many of whom will be dedicated to ESG Centers of Excellence. Even if many of these firms understand that light-green ESG investing is mostly a placebo, most are following the advice of former Citigroup CEO Charles Prince: “As long as the music is playing, you’ve got to get up and dance.”

While the fallout when the music stops will be unfortunate, a more serious harm will occur if ESG investing delays government action. Lisa Sachs, head of Columbia University’s Center on Sustainable Investment, said in August that “the major risk is that finance is purporting to solve social and environmental problems through ESG and that there’s no need for government action.” In fact, the shift in trillions of dollars of capital to “win-win” ESG funds has led some Wall Street executives to conclude just that. Speaking about public companies at a conference last year, BlackRock CEO Fink said, “We’re not going to need really governmental change or regulatory change.”

Some may infer that Fink is merely “talking [up] his own book” and trying to “further the interests of BlackRock,” as one interviewee told us, and therefore discount his comments. “Literally the only people who say that [regulation is not needed] are finance executives trying to sell products and company executives trying to avoid regulation,” the interviewee added, “and I doubt even they believe it.” Perhaps so, but we worry that average investors, citizens, and policymakers may not have the background to assess the sincerity of such remarks. From personal experience, the authors of this article know that many business students believe that ESG investing may make regulation unnecessary and are planning their careers accordingly.

Since the turn of the century and the start of the voluntary corporate social responsibility movement, carbon emissions have increased by almost 50 percent. July 2021 was the hottest month since records began. Seven hundred million people worldwide could be displaced due to water scarcity in the next decade, and the most recent Intergovernmental Panel on Climate Change report screamed code red for humanity. According to Sony Kapoor, managing director of the Nordic Institute for Finance, Technology and Sustainability, “most ESG investing is a ruse to launder reputations, maximize fees, and assuage guilt.” It also creates false hope, oversells its capacity to outperform the market, and likely contributes to the delay of long-past-due regulatory action.

Kenneth P. Pucker is a senior lecturer at the Fletcher School at Tufts University. He was formerly the chief operating officer at Timberland. Andrew A. King is a professor at the Questrom School of Business at Boston University. His research has established whether and when firms can find ways to profitably reduce their impact on the environment.