When a leading investment professional like Cliff Asness and a respected journalist like Andrew Ross Sorkin offer their opinions, mainstream investors tend to listen.
It’s unfortunate, then, that both these pundits have recently added to the confusion about the impact of ESG on investment returns. More importantly, neither offer any practical insight into how to breakthrough this confusion and how to use ESG as a value driver for both investors and society.
In a recent blog post titled “Virtue is its Own Reward: Or, One Man’s Ceiling is Another Man’s Floor,” Asness laid out his argument for why ESG investing can sometimes dampen investor returns. In the simplest terms, Asness believes that if investors decide to pursue negative screening—or its close cousin, positive screening—as part of a responsible investing strategy, then they have no choice but to sacrifice potential returns. In his words, “pursuing virtue should hurt expected returns.” His post breaks down in economic terms how everything in the market must be owned by someone, and the only way to entice more investors to hold “sin stocks” is via a lower share price. As a result, these companies will face a higher cost of capital, meaning they will need to borrow or spend more than they would have otherwise to fund various projects, expansions or research efforts. Companies that want to lower their cost of capital would therefore have to change their business practices and do less “bad stuff.”
While he makes an interesting—and likely accurate—argument, Asness presents a narrow view that may mislead readers into thinking that all ESG investing is at a negative cost to investors.
Andrew Ross Sorkin, for his part, in a recent DealBook article in the NY Times called “Can Good Corporate Citizenship Be Measured?,” reviews a number of recent studies on ESG and its impact on investment returns. He summarizes that if you’re looking for stocks that outperform their peers, simply looking at ESG. issues isn’t a panacea and that it will take more evidence—and perhaps more time–to prove itself as a good investment thesis.
Certainly, ESG is not a panacea any more than any other stand-alone set of investment factors are, but had Asness and Sorkin dug a little deeper with their research, they would have found solid evidence backed by academic studies that ESG factors strategically integrated into an investment strategy and actively managed can generate consistent outperformance.
Using ESG to create shareholder value first and foremost requires investors to identify those key issues which are material to the industry and evaluate how well companies are managing them. The Sustainability Accounting Standards Board (SASB) has done an excellent job of providing a materiality matrix for investors to work from in this regard, and the matrix is publicly available. When investors use this approach, they can expect to see a notable impact on performance. A 2016 study led by HMI board member and HBS professor George Serafeim looked at a sample of more than 2,000 U.S. companies between 1993 and 2013. The study found that companies making major investments in material ESG issues experienced both higher growth in profit margins and higher risk-adjusted stock returns than otherwise comparable companies. At the same time, and in pointed contrast, those companies that made significant investments in ESG issues that SASB deemed to be immaterial were associated with average or, in some cases, even inferior performance. As with any other investment factors, the key to ESG is to identify those ESG factors most critical to the future value of the investment.
A second step in using ESG factors to improve performance is to actively engage with companies on their ESG performance. Once again, the key is to focus this engagement on ESG issues that are material to the industry and to the company. A 2016 Harvard Business School study found that successful engagements on material ESG issues generated abnormal returns (the different between actual and expected returns) of 7.1% for investors in the 18 months following the engagement. Interestingly, Asness highlighted this exact study in one of his footnotes, clarifying that “it is always possible that more active engagement can change the equilibrium for the better.”
Engagement can come in many shapes and forms. Not surprisingly, the most passive forms of engagement—negative or positive screening—are the least likely to generate the desired results. In contrast, the more active forms of engagement, which can include everything from meeting with company executives to publicly campaigning for a specific shareholder resolution, tend to be more impactful. Research has shown that the more time and energy investors dedicate to their engagement strategies, the more likely they are to drive the change—and the financial performance—that they want.
In short, there is solid evidence that effective integration of ESG factors into an investment thesis and strategy can generate meaningful returns. Like any other investment strategy, it requires effective analysis and management. In fairness to both Asness and Sorkin, the definition and language around ESG today remains very confusing for many investors. As Sorkin notes, “The phrase itself may be in need of a makeover” and there is no doubt for many mainstream investors ESG seems a confusing set of definitions, standards and metrics. The High Meadows Institute ESG Industry Forum and groups like SASB are working on this and a more practical industry driven path forward for ESG that clearly connects to value. For more information on this and the path forward for ESG see ESG Integration in Investment Management: Myths and Realities.