What lies behind the returns from ESG investing?

Today’s mantra is that you don’t have to sacrifice performance if you own only ESG stocks. Yet that’s not logical

Last week, Eiji Hirano, former chair of the board of governors at Japan’s Government Pension Investment Fund (GPIF) – the world’s largest such fund – told Bloomberg that he sees signs of a “bubble” in ESG investing (that is, investing with environmental, social and governance issues in mind). The GPIF was an ESG pioneer in Japan, but now “needs to go back to its roots, and think about how to analyse if ESG is really profitable”. 

It’s not the only one. Investors once took it for granted that ethical investing (ESG’s predecessor) would deliver worse returns than the market as a whole. The mere fact that ESG investing means buying from a more limited universe of stocks implies that in the long run, you’ll lose out, because there will be times when the stocks you not allowed to buy outperform the ones you are.

Yet these days, ESG is often presented as a “factor” in and of itself – an investment strategy, similar to value or momentum investing, that will result in long-term outperformance due to some fundamental attribute of the stocks concerned. Robert Armstrong, in his Unhedged newsletter in the Financial Times, looks at two research papers, both by US professors Lubos Pastor, Robert Stambaugh and Lucian Taylor, which try to shed light on the matter. In theory, ESG aims to cut the “cost of capital” for “good” companies, and raise it for “bad” ones, incentivising “good” behaviours and cutting off funding to “bad” ones. 

You can argue over how effective this is (if you raise the cost of capital too much, then “bad” companies will simply go private). But even if it works, it means the ESG investor must underperform in the long run. Why? Because for a company to have a lower cost of capital, an investor must pay a higher share price or accept a lower bond yield than they otherwise would. Yet the same team found that shares with high ESG ratings beat their less ESG-friendly peers by 35% in total between 2012 and 2020. 

Why? Some argue it’s because so many ESG stocks also fit the criteria for the “quality” factor (whereby profitable stocks with strong balance sheets outperform) – the ESG label has nothing to do with it. But Pastor, Stambaugh and Taylor note that ESG outperformance is correlated with rising concerns about climate change. They argue that as a result, demand for ESG-badged products has surged faster than markets expected, driving the outperformance. In short, Hirano’s fears of a bubble look justified. In turn, as Armstrong notes, anyone investing in ESG now in the hope it will keep outperforming is betting that “the market still systematically underestimates consumers’ and investors’ taste for green products and assets – despite the fact that ESG products and funds have been very heavily promoted”. Not a bet I’d feel confident making.

Recommended

The charts that matter: more pain for goldbugs
Economy

The charts that matter: more pain for goldbugs

Gold investors saw more disappointment this week as the yellow metal took a tumble. Here’s what’s happened to the charts that matter most to the globa…
18 Sep 2021
The new social-care levy: an unfair tax that protects the “assetocracy”
National Insurance

The new social-care levy: an unfair tax that protects the “assetocracy”

The government’s regressive social-care levy will make Britain’s tax system even more complex. Root-and-branch reform is long overdue.
18 Sep 2021
Kieran Heinemann: the history of shareholder capitalism
Investment strategy

Kieran Heinemann: the history of shareholder capitalism

Merryn talks to Kieran Heinemann, author of Playing the Market: Retail Investment and Speculation in Twentieth-Century Britain, about the history of t…
17 Sep 2021
Cryptocurrency roundup: litecoin blunder, cardano update and bitcoin mining in Laos
Bitcoin & crypto

Cryptocurrency roundup: litecoin blunder, cardano update and bitcoin mining in Laos

Saloni Sardana looks at the week’s biggest stories in the world of cryptocurrencies.
17 Sep 2021

Most Popular

The times may be changing, but don’t change how you invest
Small cap stocks

The times may be changing, but don’t change how you invest

We are living in strange times. But the basics of investing remain the same: buy fairly-priced stocks that can provide an income. And there are few be…
13 Sep 2021
Two shipping funds to buy for steady income
Investment trusts

Two shipping funds to buy for steady income

Returns from owning ships are volatile, but these two investment trusts are trying to make the sector less risky.
7 Sep 2021
Should investors be worried about stagflation?
US Economy

Should investors be worried about stagflation?

The latest US employment data has raised the ugly spectre of “stagflation” – weak growth and high inflation. John Stepek looks at what’s going on and …
6 Sep 2021