PAPERS WE’RE READING: “Honey, I Shrunk the ESG Alpha”: Risk-Adjusting ESG Portfolio Returns

Over the last decade, people have become increasingly concerned with the environment and corporate America’s impact on it. This development, along with increased concern for social issues and labor rights, has led many investors to integrate environmental, social, and governance (ESG) criteria into their equity portfolios.

In their paper “‘ Honey, I Shrunk the ESG Alpha’: Risk-Adjusting ESG Portfolio Returns,” authors Giovanni Bruno, Mikheil Esakia, and Felix Goltz examine the performance of ESG strategies and the value they can offer to investors.

Giovanni Bruno is a Senior Quantitative Analyst at Scientific Beta and a member of the EDHEC Scientific Beta research chair. Mikheil Esakia is a quantitative research analyst at Scientific Beta, and Felix Goltz, Ph.D., is Research Director at Scientific Beta.

The authors began their paper by identifying the four important motivations behind incorporating ESG into an equity portfolio: aligning portfolios with investors’ values and norms; making a social impact by pushing companies to act responsibly; reducing exposure to risks faced by ESG laggards, such as climate or litigation risk; and generating performance by favoring ESG leaders.

The paper focused on the fourth motivation, as ESG is often perceived as a source of outperformance, a view ESG providers are fond of endorsing. The authors examined five different papers that analyzed different ESG strategies that conclude there is a positive alpha from ESG investments.

The authors were skeptical of the evidence of positive alpha from ESG investments. The unclear credibility of these claims requires investors to ask whether non-financial information in ESG scores offers additional performance benefits, precisely what this paper sought to address.

“Investors need to ask whether the promise of generating outperformance from ESG leaders is credible. Claims of outperformance may be based on simple returns from ESG strategies or on returns after adjusting for market exposure alone. However, such a simplistic view of performance is insufficient. Even if ESG strategies have higher returns, investors do not gain if these returns are due to sector biases or exposure to standard factors,” wrote the authors.

In conducting their analysis, the authors began by using monthly ESG rating data from MSCI from January 2007 to June 2020 to give ESG investments a rating. From there, the authors constructed three types of strategies based on the relevant literature.

The first was based on the overall ESG score and component scores (E, S, and G). The strategy was to pick stocks based on their overall ESG score, or the score for one of the three components. The second was the ESG Momentum score strategy, done by selecting stocks based on their ESG Momentum, defined as the change of their ESG score over 12-months. This second strategy excluded stocks with missing and zero ESG Momentum scores. Finally, the third strategy combined the scores (ESG and ESG Momentum). This was done by selecting 30% of stocks in the long leg, then selecting 40% of stocks with the highest ESG score and excluding 10% of stocks with the lowest ESG Momentum. Then, the short leg selects 40% of stocks with the lowest ESG score and then excludes 10% of stocks with the highest ESG Momentum.

Next, the paper turned to factor exposures and sector biases. The basic risk and return statistics for ESG strategies revealed that the simple performance of ESG strategies looks positive. The data showed that ESG strategies have positive returns that can be economically large, with up to almost 3% per year. Findings also showed a positive alpha for risk-adjusted returns on ESG investments.

The authors point to quality factors as one of the more important factors in ESG returns.
“It is clear from these results that returns of the ESG strategy heavily depend on quality factors. For example, the US strategy that uses aggregate ESG ratings has a contribution from quality factors of about 1.7% per year, exceeding its annualized returns of about 1.3%…For the strategy using overall ESG ratings outside the US, the quality factors contributed roughly to one-third of its returns. The return contribution of quality factors to the other types of strategies is also substantial when compared to their annualized returns,” wrote the authors.

Moving beyond simple returns, when factoring in sector biases, the authors found that none of the sector-neutral strategies show significant alpha in any model. The finding implies that ESG ratings were not a separate source of outperformance for investors over the sample period. Instead, ESG strategies implicitly tilted to different sectors, such as technology, and equity style factors, such as quality, and these tilts may have paid off over the sample period.

The authors’ findings suggested that when factoring in sector neutrality and exposure to standard factors, ESG strategies consistently deliver zero alpha. Figures of unadjusted returns are more popular in the investment industry to showcase instead of figures of risk-adjusted returns. The authors believed this finding comes from a preference among product providers for upward-sloping lines.

The authors turned next to the claim that ESG ratings capture risk exposures that stem from environmental, social, and governance issues. Therefore, ESG leaders may be less risky than ESG laggards. The analysis in that section found that accounting for downside risk exposure does not increase alphas. None of the strategies showed a significantly positive alpha when using the full set of factors either with or without accounting for downside risk exposure.

The authors demonstrated that ESG strategies did not deliver value-added to investors in financial performance over an extended period. The authors noted that if attention to ESG shifts upwards, ESG strategies may have positive short-term performance, but their long-term expected returns decline.

Should this attention shift occur, the authors suggest that investors need to conduct two adjustments to observed returns to form realistic expectations. First, returns of ESG strategies over periods with upward attention shifts are inflated, so investors will need to deflate returns by subtracting the tailwind from rising attention. Second, following upward attention shifts, long-term expected returns will be even lower than before the shifts occurred. Therefore, investors will need to adjust the deflated returns and subtract the drag imposed by rising valuations that occurred because of rising attention.

In conclusion, the authors reiterated that while many ESG strategies have positive returns, adjusting these returns for risk shrinks alpha to zero. The authors caution that their findings are specific to their data set, but they believe in the validity of their conclusion that there is no positive alpha for ESG strategies.

These findings have potentially important implications. Their analysis provides an example of how one can document outperformance where there is none. Furthermore, investors need to look beyond alpha if they want to use ESG as an investment strategy if there is no evidence of outperformance from ESG when adjusted.

Giovanni Bruno is a Senior Quantitative Analyst at Scientific Beta and a member of the EDHEC Scientific Beta research chair. His research focuses on asset pricing. He earned his PhD in finance at the Norwegian School of Economics, where he also worked as a Teaching Assistant delivering courses on Investments, Derivatives and Risk Management and Quantitative Investment. He holds a Master’s Degree from LUISS Guido Carli University (Italy), where he obtained First-Class Honours in Quantitative Finance.

Mikheil Esakia is a quantitative research analyst at Scientific Beta. He does research in empirical finance, with a focus on the relation of macro-economy and equity markets, portfolio construction, and liquidity of systematic equity strategies. He has co-authored various articles published in practitioner journals and magazines. He obtained master’s degree in Finance from EDHEC Business School after studying business administration at Free University of Tbilisi.

Felix Goltz, Ph.D., is Research Director at Scientific Beta. He carries out research in empirical finance and asset allocation, with a focus on alternative investments and indexing strategies. His work has appeared in various international academic and practitioner journals and handbooks. He obtained a PhD in finance from the University of Nice Sophia-Antipolis after studying economics and business administration at the University of Bayreuth and EDHEC Business School.

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