Is ESG outperformance a ripple or a wave? Is ESG outperformance a ripple or a wave? Is ESG outperformance a ripple or a wave?

Is ESG outperformance a ripple or a wave?

Equities 8 minutes to read
PG
Peter Garnry

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.

Source: MSCI

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?

Source: Bloomberg

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.

Disclaimer

The Saxo Group entities each provide execution-only service and access to Analysis permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Saxo News & Research and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Group by which access to Saxo News & Research is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Saxo News & Research or as a result of the use of the Saxo News & Research. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. Saxo News & Research does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws.

Please read our disclaimers:
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)
- Full disclaimer (https://www.home.saxo/en-hk/legal/disclaimer/saxo-disclaimer)

None of the information contained here constitutes an offer to purchase or sell a financial instrument, or to make any investments. Saxo does not take into account your personal investment objectives or financial situation and makes no representation and assumes no liability as to the accuracy or completeness of the information nor for any loss arising from any investment made in reliance of this presentation. Any opinions made are subject to change and may be personal to the author. These may not necessarily reflect the opinion of Saxo or its affiliates.

Saxo Capital Markets HK Limited
19th Floor
Shanghai Commercial Bank Tower
12 Queen’s Road Central
Hong Kong

Contact Saxo

Select region

Hong Kong S.A.R
Hong Kong S.A.R

Saxo Capital Markets HK Limited (“Saxo”) is a company authorised and regulated by the Securities and Futures Commission of Hong Kong. Saxo holds a Type 1 Regulated Activity (Dealing in Securities); Type 2 Regulated Activity (Dealing in Futures Contract); Type 3 Regulated Activity (Leveraged Foreign Exchange Trading); Type 4 Regulated Activity (Advising on Securities) and Type 9 Regulated Activity (Asset Management) licenses (CE No. AVD061). Registered address: 19th Floor, Shanghai Commercial Bank Tower, 12 Queen’s Road Central, Hong Kong.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Trading in leveraged products may result in your losses exceeding your initial deposits. Saxo does not provide financial advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo does not take into account an individual’s needs, objectives or financial situation. Please click here to view the relevant risk disclosure statements.

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-hk/about-us/awards.

The information or the products and services referred to on this site may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and services offered on this website are not directed at, or intended for distribution to or use by, any person or entity residing in the United States and Japan. Please click here to view our full disclaimer.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc. Android is a trademark of Google Inc.