Is ESG outperformance a ripple or a wave?
Head of Equity Strategy
Summary: ESG strategies are expected to consume a third of global assets under management by 2025 and investors are buying the projection with eager, but also underpinned by promises of outperformance from doing good. Passive ESG indices show little outperformance, with the majority being explained by overweight the technology sector, and many active ESG strategies do not offer an unique source of outperformance when adjusting for standard factors and sectors. In addition to these findings ESG is lacking a proper standard and biases towards large companies.
ESG (environmental, social, and governance) is on everyone’s lips these days in financial markets with some analyses expecting assets under ESG mandates to hit $53trn by 2025, a third of global asset under management (AUM), making it a powerful trend. One of the biggest issues of ESG is the lack of an industry standard on how to define it and especially for companies with very long value chains such as an ESG darling such as Tesla. However, the world’s largest index provider on equities, MSCI Inc., is trying to create a rules-based framework for ESG. has In this analysis we take a look at ESG performance to see whether it drives real outperformance or it should be seen more as a hygiene factor for investors and especially large pension funds.
A ripple or a wave?
The largest ESG ETF on the MSCI World Index is the iShares MSCI World ESG Enhanced UCITS ETF with $1.77bn in AUM and was launched on 16 April 2019 and tracks the MSCI World ESG Enhanced Focus Index. This index is designed to maximize exposure to positive environmental, social, and governance factors. The chart below shows the difference between this ESG enhanced index and the traditional MSCI World Index. Over this nine year period the ESG enhanced index has delivered 0.4%-pts annualized outperformance which is such a small difference that investors investing in this passive index are not doing it for the returns but for the signaling value to their clients or own conscience.
When we look at the outperformance the majority of the outperformance has come since early 2020, which has coincided with information technology outperforming global equities. Not surprisingly, most ESG indices have an overweight on technology companies because they are estimated to have a lower carbon emission footprint.
In a recent EDHEC Scientific Beta paper Bruno et. al. find no evidence supporting the claims that active ESG strategies generate outperformance. The authors analyze 12 different ESG strategies and as soon as returns are adjusted for standard factors and sectors then the outperformance disappears and can mostly be explained by standard quality factors which can mechanically be derived from balance sheet figures. The authors also show that the increased awareness of ESG and subsequent inflows into ESG funds explain some of the outperformance; in essence the dog chasing its own tail.
The fact that ESG does not deliver a unique source of outperformance does not mean that ESG does not add value to investors. As said it is valid value if it aligns investments more with the general public’s views on ESG and thus this hygiene filter as a business purpose.
Alphabet as an ESG example
One of the stocks that constantly have a high weight in most ESG funds is Alphabet (Google’s parent company) and since Alphabet has done well over the years it has added to performance. When we look at the ESG ratings in the Bloomberg terminal several things stand out. The different ESG scores vary greatly as they all have different methodology and emphasizes different things. The MSCI rating is BBB which means Alphabet is average while S&P Global ESG Rank is 96 (0-100 scale) ranking it at the very top. In other words, if investors rely on a single ESG score they will likely miss something.
Another striking observation is Bloomberg’s GHG/revenue ratio which basically rewards companies for generating the most business activity with the least greenhouse gasses emitted. The problem with this score is that it rewards large companies as these enjoy economics of scale that is larger than smaller companies and thus on average will have a tendency to score better on this metric.
Under governance it is also striking that Alphabet’s dual share class structure is not part of the governance rating. Many technology companies which are overweight in ESG funds come with dual share class (Alphabet, Facebook etc.) to ensure majority control for the founders. But this in effect creates large companies with little opportunity for external pressure and limits the board’s power. Should we prefer single class share companies over dual class in an ESG centric world?
The AUM capacity dilemma
Another dilemma in ESG investing is that the current methodologies applied by the various rating firms favour large over smaller companies as they rely on ESG reports and other disclosure reports, which are costly and cannot easily be justified by smaller companies. Another intrinsic bias among rating companies to favour large companies over smaller is that it makes it possible to create indices with high liquidity and AUM capacity, which is essential if you want the ESG index mandate from the big asset management firms such as Vanguard and BlackRock. According to MSCI, they recognize the size bias, but also says that it has been declining over the years.