Scientific Beta looks behind the numbers of ESG performance and finds quality issues. Lynn Strongin Dodds reports.
Sustainable investing has gained traction not only because of the ethical component but also the enhanced returns that have been reported over the past year. However, research from independent index provider Scientific Beta, which is part of the EDHEC-Risk Institute, shows that outperformance can be explained through sector biases and exposures to equity style factors as well as greater inflows.
The paper – Honey I Shrunk the ESG Alpha is co-authored by Dr Felix Goltz, Scientific Beta research director, Dr Giovanni Bruno, senior quantitative analyst at Scientific Beta and a member of the EDHEC Scientific Beta research chair, and Mikheil Esakia, a quantitative research analyst at Scientific Beta.
The research looked at the wider claims that showed environmental, social and governance (ESG)-based funds fared better than their peers particularly during the pandemic-driven sell off of March-April 2020. There have been several studies to that effect such as the one on MSCI ESG Leaders indices which target companies that have the highest ESG-rated performance in each sector of the parent index.
Over the longer-term separate analysis from Morningstar showed six out of its ten European sustainable funds delivered higher returns than equivalent conventional funds over the past decade. This was also the case over three and five years of the sample of 745 Europe-based sustainable funds examined.
The study used MSCI’s ESG ratings data from January 2007 to June 2020 to take a deeper look into these strategies, their components and drivers of performance.
The authors analysed standard factors as well as a time series, multi-factor regression model with seven factors: the market, value, size, momentum, low volatility, high profitability and low investment factors
Six different ESG strategies in the US as well as other developed markets were tested. They included long, short and momentum, and were developed based on high-profile academic papers.
The research found evidence that ESG funds tended to outshine their counterparts, with ESG leaders typically beating ESG laggards by almost 3 percentage points a year. However, in both the US and other developed markets, quality factors such as profitability (gross profits divided by assets) and the conservative nature of investment accounted for 75% of the outperformance.
Quality, which can easily and cheaply be accessed through systematic funds, is a well-established premium or source of return that academic research has proven traditionally generates better returns than the market over long-term economic cycles.
The paper said, “Despite relying on analysis of non-financial information by hundreds of ESG analysts, ESG strategies perform like simple quality strategies mechanically constructed from accounting ratios.
The authors added, “We conclude that claims of positive alpha in popular industry publications are not valid because the analysis underlying these claims is flawed. Omitting necessary risk adjustments and selecting a recent period with upward attention shifts enables the documenting of outperformance, where in reality there is none.”
They added that ESG strategies also did not offer a particularly strong buffer. “Accounting for exposure of the strategies to a downside risk factor does not alter the conclusion that there is no value-added beyond implicit exposure to standard factors such as quality [as an investment strategy].”
Many market participants were not surprised by the findings noting there is a strong link between quality companies and ESG. They are typically more sustainable and have the resources to spend time and money on ESG initiatives such as improving diversity and inclusion and offsetting their carbon footprint.
The Scientific Beta report also attributed gains last year to ESG strategies having a heavy bias towards technology, which had a stellar 2020, as well as the growing popularity of sustainability funds. Figures from Morningstar show that total assets hit a new high, increasing 19% to nearly $2 trillion in the first quarter. In other words, as investors pour money into stock or securities, their prices often rise in tandem.
The report said, “Flows into sustainable mutual funds show that attention to ESG has risen remarkably over the later period of our sample, from about 2013. We find that alpha estimated during low-attention periods is up to four times lower than alpha during high-attention periods. Therefore, studies that focus on the recent period tend to overestimate ESG returns.”
Dr Noël Amenc, CEO of Scientific Beta noted that “Investors should ask how ESG strategies can help them to achieve objectives other than alpha, such as aligning investments with their values and norms, making a positive social impact, and reducing climate or litigation risk. These results also question the way in which ESG providers, and the investment industry more generally, promote ESG.
He added, “By relying on biased research results, which as such have no value, the promoters of alpha in ESG investing are taking the great risk of disappointing investors on this supposed outperformance and diverting them in time from an investment theme that is important for sustainable economic development.”
©Markets Media Europe 2021
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