No evidence for ESG alpha, claims new study

‘Claims of positive alpha in popular industry publications are not valid because the analysis underlying these claims is flawed,’ state the authors of a new study looking at whether ESG metrics deliver outperformance as is widely claimed.

New academic research from Scientific Beta, a ‘smart beta’ index provider, and published in the paper Honey, I shrunk the ESG alpha, shows that ESG funds outperform based on ‘quality’ factors rather than ESG metrics.

The findings have ‘important implications for investors,’ according to Scientific Beta. More generally, the analysis provides ‘an example of how one can document outperformance where there is none: it is sufficient to omit necessary risk adjustments.’

Looking specifically at ESG strategies, ‘the findings question a widespread practice of using ESG as an alpha signal,’ say the researchers, though they add that the findings do not question the added value of such strategies on other dimensions, especially on the financial materialization of extreme risk reduction, ‘which still requires serious studies that are forthcoming.’

Dr Noël Amenc, CEO of Scientific Beta, explains in a press release announcing the study findings that ‘omitting necessary risk adjustments and selecting a recent period with upward attention shifts enables outperformance to be documented where in reality there is none.’

He says the findings should prompt a shift in how some investors view ESG. ‘Investors should ask how ESG strategies can help them to achieve objectives other than alpha, such as aligning investments with their values and norms, making a positive social impact, and reducing climate or litigation risk,’ he explains.

‘These results also question the way in which ESG providers, and the investment industry more generally, promote ESG. By relying on biased research results – which as such have no value – the promoters of alpha in ESG investing are taking the great risk of disappointing investors on this supposed outperformance and diverting them in time from an investment theme that is important for sustainable economic development.’

Analyzing 24 ESG strategies that have been shown to outperform in other academic papers, Scientific Beta does find evidence that ESG funds have tended to outperform: ‘Simple returns of ESG strategies look attractive, with annualized returns of up to almost 3 percent per year.’

But the researchers constructed ESG strategies that had been shown to outperform in other research papers and find that ‘when accounting for exposure to standard factors, none of the 12 different strategies we constructed to tilt to ESG leaders adds significant outperformance, whether in the US or in developed markets outside the US.’ Instead, researchers find that ‘75 percent of outperformance is due to quality factors that are mechanically constructed from balance sheet information.’

They add that ESG strategies do not offer significant downside risk protection, either. ‘Accounting for exposure of the strategies to a downside risk factor does not alter the conclusion that there is no value-added beyond implicit exposure to standard factors such as quality [as an investment strategy].’

Investor attention on ESG has also played a role, according to the paper: ‘Flows into sustainable mutual funds show that attention to ESG has risen remarkably over the later period of our sample, from about 2013. We find that alpha estimated during low-attention periods is up to four times lower than alpha during high-attention periods. Therefore, studies that focus on the recent period tend to overestimate ESG returns.’