AQR: Here’s What ESG Really Does to Portfolios

An AQR principal and two managing directors try to find a balance between the costs and benefits.


Are ESG strategies good for portfolios, or do they drag down returns? The answer, according to a trio of AQR researchers: It’s complicated.

In new paper titled “Responsible Investing: The ESG-Efficient Frontier,” AQR principal Lasse Pedersen and managing directors Shaun Fitzgibbons and Lukasz Pomorski propose a model that balances the potential costs and benefits of ESG-based investing, taking into account investor preferences regarding environmental, social, and governance issues.

In developing the model, they discovered that while some ESG measures predict higher returns, others lead to worse performance, and still others have a seemingly negligible impact on the portfolio.

“We submit that if ESG is a positive predictor of future firm profits, then ESG is also a positive predictor of returns as long as the value of ESG is not fully priced in the market,” Pedersen, Fitzgibbons, and Pomorski wrote. “Further, the model predicts that this relationship may be weakened with ESG becoming a neutral predictor when most investors see the value in ESG, and even flips sign, with ESG becoming a negative predictor of returns, when investors are willing to accept lower returns for more responsible stocks.”

Good corporate governance, for example, was found to be a positive predictor of future profitability. Although the AQR researchers noted that investor demand for these types of stocks has increased, they said it hasn’t yet reached the point of making high-governance stocks more expensive. Rather, these stocks trade at “relatively cheaper” valuations, and “subsequently exhibit significant positive abnormal returns,” the authors said.

On the other hand, so-called “sin stocks” — alcohol, tobacco, and gaming companies — have similar profitability prospects as non-sin stocks, but are much less in demand among investors, causing them to trade at cheaper valuations.


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Overall, the AQR researchers’ model determined that the impact of ESG on investment performance was dependent on how much the market at large utilized ESG information. When most investors ignore environmental, social, and governance considerations, ESG is a source of alpha. But as more investors utilize ESG information, that alpha diminishes.

“Investors bid up the prices of high ESG stocks to exactly reflect their expected profits, thus eliminating the connection between ESG and expected returns,” the authors wrote.

ESG’s impact was also dependent on how investors implemented their environmental, social, and governance strategy. Negative screens, for instance, have long been associated with lower expected performance — a result the AQR research confirmed. “Constraints reduce a portfolio’s expected performance,” the authors noted.

Interestingly, the authors found that these negative screens not only hurt performance, they could lower the portfolio’s overall ESG score, if investors are optimizing their portfolios for the highest possible Sharpe ratio.

“Low-ESG assets may be useful hedging instruments for high-ESG assets, and may help the investor improve the Sharpe ratio of the overall portfolio, potentially by increasing their investment in high-ESG securities,” the authors explained. “With screening the investor may optimally choose portfolios that do not take a large position in high-ESG assets.”

Meanwhile, two other ESG proxies that the AQR researchers considered — carbon output and ESG scores produced by MSCI — were not found to have any correlation with company fundamentals or subsequent investment returns.

“Investors, especially institutions such as pension funds… want to own ethical companies in a saintly effort to promote good corporate behavior, while simultaneously hoping to do this in a guiltless way that doesn’t sacrifice the investor’s returns,” the authors wrote. “Investors must realistically evaluate the costs and benefits of responsible investing, and we hope that our framework will be a useful way to conceptualize and quantify these costs and benefits.”