Swedroe: Socially Responsible Investing’s Results

Equity strategies that target environmental, social and governance (ESG) issues consider not just their stock return but the effects their investments have on other stakeholders, such as firm employees and individuals affected by the environmental decisions of the firms in which they invest.

ESG strategies have exploded in popularity. The Global Sustainable Investment Alliance recently estimated that $22.9 trillion worldwide is managed under the auspices of “responsible investment strategies,” a 25% increase just since 2014, and which now represents roughly 26% of all assets under professional management.

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 I reviewed in a recent article has confirmed the evidence supports the theory.

While 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 could be subject to greater risk (that is, a wider range of potential outcomes) than their more ESG-focused counterparts. Again, academic research confirms the evidence supports this hypothesis.

Thus, when it comes to ESG investing, it appears that two forces are at work: lower returns and lower risk. One hypothesis is that the two might offset each other in terms of delivering risk-adjusted returns.

Latest ESG Research

Jason Hsu, Xiaoyang Liu, Keren Shen, Vivek Viswanathan and Yanxiang Zhao contribute to the literature on ESG investing with their study “Outperformance through Investing in ESG in Need,” which was published in the fall 2018 issue of The Journal of Index Investing. Their study covered the period July 2006 through December 2017. Their data set included the 500 largest companies by market capitalization at the start of each year. The sources of their data on ESG scores were Bloomberg and Thomson Reuters.

Following is a summary of their findings:

• Consistent with the “shunning hypothesis,” top-rated ESG companies generally underperform bottom-rated companies, although the data was not statistically significant. Using Bloomberg scores, on a cap-weighted basis, the top ESG-rated firms underperformed by -0.4% (t-stat: -0.2). Using Thomson Reuters scores, they underperformed by -0.7% (t-stat: -0.4).
• Regressions using the Carhart four-factor model (market beta, size, value and momentum) showed alphas very close to zero with very low t-stats.

Hsu, Liu, Shen, Viswanathan and Zhao then examined whether screening for ESG firms with a high cost of capital would improve returns. For each top ESG universe, they sorted the stocks according to their cost of equity into quintile portfolios. The characteristics chosen to estimate cost of equity are book-to-market, gross profitability, net operating assets, accruals, gross profitability, volatility, asset growth and market beta.

Not surprisingly (the flip side of a high cost of capital is a high expected return to the provider of that capital), they found it did—firms with a higher cost of equity capital (what they called “ESG in need”) tend to outperform firms with a lower cost of equity.

Using Bloomberg scores, the firms with high costs of capital outperformed the firms with low costs of capital by 7.3% (t-stat: 1.9). Using Thomson Reuters scores, the outperformance was 6.9%, and the data were statistically significant at the 5% level of confidence (t-stat: 2.2).

Using the S&P 500 as the benchmark, the authors found that a high cost of capital ESG strategy outperformed by about 3% per annum, with an annual turnover of about 60% (trading costs should be very low given that the universe is the 500 largest stocks).

More Supporting Evidence

These findings are consistent with those of Andre Breedt, Stefano Ciliberti, Stanislao Gualdi and Philip Seager, authors of the July 2018 study “Is ESG an Equity Factor or Just an Investment Guide?” They concluded: “Any benefit from incorporating ESG credentials into a portfolio is already captured by other well-defined and known equity factors. An ESG-tilted process does not deliver higher risk-adjusted returns.”

While the evidence from these two studies demonstrates that ESG information yields no additional benefit, importantly, neither does it appear to negatively affect risk-adjusted returns. It does, however, allow investors to express their social views through their investments without any expected penalty, at least in terms of risk-adjusted returns.

In addition, the data show that if ESG investors are willing to “tilt” their portfolios to those ESG firms with higher costs of capital, they can “eat their cake” (express their social views) and have it too (earn higher expected returns).

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