Is ESG Outperformance Just an Illusion?

Research suggests the excess returns delivered by ESG funds come from a source other than companies’ environmental, social, and governance records.

David Paul Morris/Bloomberg

David Paul Morris/Bloomberg

Proponents of ESG argue that there are not just moral benefits to investing according to environmental, social and governance goals: ESG funds also outperform their peers.

But those excess returns may really be coming from another source, according to research from Scientific Beta.

Scientific Beta, set up by EDHEC-Risk Institute in 2012 and now majority-owned by Singapore Exchange, has found that 75 percent of the outperformance of ESG strategies cited in popular academic studies on the subject was due to their exposure to the quality factor, which can be cheaply accessed through systematic funds. Quality is a well-known premium, or source of return, that academic research has shown outperforms the market over long-term economic cycles.

In a report not yet published but seen by Institutional Investor, Scientific Beta deconstructed the reported ESG performance gains to account for the potential contribution of sector tilts, factor exposures, and attention shifts, meaning the steadily growing popularity of strategies over the time period that was studied. The research group also evaluated whether incorporating ESG factors protected investors from losses, another popular claim of ESG asset managers.

“We find that over the past decade these strategies did deliver positive returns,” Felix Goltz, Scientific Beta’s research director and one of the authors of the study, said in an interview. “One example is the outperformance of a fund that holds long positions in ESG leaders and short positions in ESG laggards.”


Goltz said he wanted to quantify the specific performance that could be attributed to ESG, once everything was adjusted for generic factors, such as equity styles and industry sectors, a common practice in attribution analysis. “Well, it disappears,” he said.

Scientific Beta found that the recent strong performance of these strategies is also linked to a phenomenal increase in investor attention, measured by the flow of money into the funds, particularly since 2013. As investors plow money into stocks or securities, their prices often rise in tandem.

When fund flows were low relative to other periods, alpha, or excess returns, was up to four times lower than the returns above the benchmark when investor attention was high. Flows were never negative during the time period studied, according to the report.

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“We conclude that claims of positive alpha in popular industry publications are not valid because the analysis underlying these claims is flawed,” the authors wrote. “Omitting necessary risk adjustments and selecting a recent period with upward attention shifts enables the documenting of outperformance where in reality there is none.”

Sheru Chowdhry, founder and chief investment officer of DSC Meridian — and the former head of credit research and co-portfolio manager at Paulson & Co — said he wasn’t surprised that ESG equity outperformance was attributable to funds owning higher quality companies.

Even though research of this type hasn’t been done for ESG credit funds, Chowdhry said the quality argument is just as important in analyzing high-yield bonds. DSC Meridian recently launched the first distressed and event-driven credit hedge fund investing with ESG-related objectives.

“Higher quality companies attract the best human talent and are more sustainable, in part because they avoid all the wrong doings that companies can be drawn into,” he said. “It can be very circular. Quality companies have higher multiples, which then attract higher fund flows, leading to sustainably higher multiples.”

He said his firm’s research approach incorporates ESG factors, but it’s never just one rating and it’s always coupled with financial analysis. “As a credit investor, if I do my diligence right and understand and avoid non-financial risks such as work force health and safety, data privacy, or decarbonization, then the high-yield companies I own will have a lower risk of default,” he said.

To come up with its findings, Scientific Beta used monthly ESG ratings data from MSCI, also known as IVA, or Intangible Value Assessment, from January 2007 to June 2020. The researchers tested six different ESG strategies in two different markets, the U.S. and developed markets excluding the U.S. The strategies included long-short and momentum, and were developed based on high-profile academic papers.

Goltz said he thinks sustainable funds have plenty of value in terms of their potential impact on society, but outperformance isn’t one of them.

“We’re not saying that ESG strategies or ratings have no use to investors,” he said. “We are only asking whether we get performance benefits and are they credible?”