Swedroe: ESG Risk & Return Implications

May 29, 2018

Environmental, social and governance (ESG) investment strategies—along with the narrower category of socially responsible investing (SRI)—have gained quite a bit of traction in portfolio management in recent years.

In 2016, funds based on such strategies managed about $9 trillion in assets from an overall investment pool of $40 trillion in the United States, according to data from US SIF. In addition, the organization’s 2016 survey of sustainable investment assets found that in the U.S., climate change was the most significant environmental factor influencing asset allocations.

Value Play In ‘Sin’ Stocks?

While ESG investing continues to gain in popularity, economic theory suggests that if a large enough proportion of investors chooses to avoid “sin” businesses, the share prices of such companies will be depressed. They will have a higher cost of capital because they will trade at a lower price-to earnings (P/E) ratio.

Thus, they would offer higher expected returns (which some investors may view as compensation for the emotional “cost” of exposure to what they consider offensive companies).

Academic research has confirmed that the evidence supports the theory.

Higher Fees OK

Interestingly, Arno Riedl and Paul Smeets, authors of the study “Why Do Investors Hold Socially Responsible Mutual Funds?”, which appears in the December 2017 issue of The Journal of Finance, found that investors are willing to pay significantly higher management fees on SRI funds than on conventional funds, and that a majority of them expect such funds to underperform relative to conventional funds.

In other words, investors understand there is a price (in the form of lower expected returns) for expressing their social values, and are willing to pay it.

Impact On Risk?

Jeff Dunn, Shaun Fitzgibbons and Lukasz Pomorski of AQR Capital Management contribute to the literature concerning ESG investing with their February 2017 study, “Assessing Risk through Environmental, Social and Governance Exposures.”

While other studies focused on the impact of ESG/SRI investing on returns, the authors’ focus was on the risk side of the strategy. Just as it is logical to expect that investors shunning certain stocks should lead to those stocks having higher future returns, it is also logical to hypothesize that companies neglecting to manage their ESG exposures may be exposed to higher risk (a wider range of potential outcomes) than their more ESG-focused counterparts.

Risk Of ESG Neglect

The authors used the MSCI ESG database (often referred to as intangible value assessment, or IVA, data) and Barra risk models to determine whether there was any link between the two. The IVA methodology covers a large cross section of companies around the world (more than 5,000 companies as of December 2015 accounting for 97% of the market cap of the MSCI World Index) and assesses how much each company is exposed, and how well it manages its exposure, to a range of environmental, social and governance issues affecting its industry.

Dunn, Fitzgibbons and Pomorski employed the Barra GEM2L risk model to determine forward-looking (ex-ante) risk estimates. Specifically, a stock’s returns are assumed to be driven by a combination of its loadings on systematic risk factors and by firm-specific “idiosyncratic” effects, which are assumed to be uncorrelated across assets. The authors’ sample period is January 2007 to December 2015.

Following is a summary of their findings:


  • ESG exposures are informative about the risks of individual firms. This finding is robust to a wide variety of controls and various stock universes (U.S., developed and emerging markets).
  • Stocks with the worst ESG exposures have total and stock-specific volatility up to 10-15% higher, and betas up to 3% higher, than stocks with the best ESG exposures.
  • ESG scores may help forecast future changes to risk estimates from a traditional risk model. Controlling for contemporaneous risk model estimates, poor ESG exposures predict increased future statistical risks. The magnitude of the effect was relatively modest: A deterioration of ESG score from the 75th to the 25th percentile is associated with about a 1% increase in risk. While this increase might seem small, it may simply reflect the fact that ESG captures risks that are long-run in nature and that may not materialize in the short-to-medium term.
  • Across the three dimensions of ESG investing, the social and governance pillars show the strongest correlation to risk. The environmental pillar is only insignificantly related to the various risk measures.
  • Stocks in the first (worst) quintile of ESG scores had greater earnings volatility and were less profitable than stocks in the fifth (best) quintile. They also had more exposure to the value factor. Furthermore, they had lower Ohlson scores (a measure of default risk). Additionally, they were smaller companies. Each of these findings is related to risk and highly statistically significant. Stocks in the first quintile also had more exposure to the momentum factor than stocks in the fifth quintile. This also was statistically significant.
  • Consistent with theory and prior research, stocks in the first quintile of ESG scores earned 1.8% higher returns than stocks in the fifth quintile. However, while certainly economically significant, this difference was not statistically different from zero at the 5% confidence level (t-stat of 1.2). (Note that this lack of statistical significance could be due to the limitation of the short period covered by the study.) The higher returns might be a premium that investors earn for the displeasure of holding such stocks, possibly as compensation for the additional risks (such as greater earnings volatility, less profitability and greater default risk) these stocks exhibit.

What Risk Exposures Convey

Dunn, Fitzgibbons and Pomorski concluded: “ESG exposures convey information about risk that is not captured by traditional statistical risk models.”

They added: “While the effect is modest in magnitude, it is consistent with ESG exposures conveying some information about risk that is not captured by traditional statistical risk models. Overall, our findings suggest that ESG may have a role in investment portfolios that extends beyond ethical considerations, particularly for investors interested in tilting toward safer stocks. ESG exposures may inform investors about the riskiness of the securities in a way that is complementary to what is captured by traditional statistical risk models.”

The authors included this note of caution: “It would be surprising if ESG were a first-order driver of a stock’s risk beyond what is already captured in a well-constructed statistical risk model. ESG may convey information about, say, the likelihood of a governance scandal, but such a scandal may not materialize for the average company over a relatively short horizon we study here. Moreover, ESG exposures are fairly persistent and stocks with poor ESG profile tend to be poor ESG also in the future.”

The bottom line is that, while ESG investors seem likely to be sacrificing some returns to express their social preferences through their investments, it also seems likely there may be some offsetting benefit, though it may be marginal, in the form of reduced portfolio risk.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.

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