When investors use environmental, social, and governance factors to choose companies to invest in, they don’t outperform, research shows.
But when ESG factors are combined with high employee satisfaction, shareholders reap the rewards, according to new academic research from Kyle Welch at George Washington University and Aaron Yoon at Northwestern University.
Their paper, published Tuesday, shows that portfolios made up of companies with high ESG ratings and high employee satisfaction outperform firms with low ratings by 5.61 percent on an equal-weighted basis, and 5.83 percent on a value-weighted basis.
“The big question I had in mind was how do you generate alpha from ESG?” Yoon told Institutional Investor by phone Tuesday.
According to Yoon, the research he has done has not shown that ESG measures alone improve returns. High employee satisfaction, however, improves annual shareholder returns on its own by roughly three percent, he said, and his research with Welch verified that.
“We know that employee satisfaction is related to firm value and enhancing stock returns,” Yoon said. “Before doing this work, we didn’t know what the role of ESG is in shaping that relationship.”
Yoon and Welch used data from employee-rating site Glassdoor and MSCI’s ESG ratings and built equal- and value-weighted portfolios of companies.
They chose Glassdoor because it requires an active email address or social networking account, which can help prevent a company from promoting itself. The company also uses an algorithm and a human team to detect and delete fraudulent reviews.
The researchers then set up portfolios of companies using a “double sort” function, which allowed them to create portfolios using both ESG scores and employee satisfaction ratings.
The equal-weighted portfolio of companies with high ESG and high employee satisfaction outperformed a portfolio of companies with low ESG scores but high employee satisfaction by 2.75 percent, the research showed.
This portfolio with high ESG scores and strong employee satisfaction outperformed a portfolio of companies with high ESG performance and low employee satisfaction by 5.64 percent. In other words, when high employee satisfaction is coupled with high ESG scores, the outperformance is meaningful.
“For ESG to work, employee satisfaction seems like a necessary condition,” Yoon said. “Employees are so very important. They’re not just raw materials.”