Over the last few years, one of the key trends in the management of portfolio has been the incorporation of ESG stocks. There has been rapid growth in the forms of sustainable finance, as increased number of the institutional investors and funds incorporate different approaches of the Environmental, Social and Governance investment. As per the Global Sustainable Investment Alliance, around $21.4 trillion was managed by some form of SRI- Socially Responsible Investing at early 2014, signifying around 30 percent of the overall global assets under management[1].
The growing interest of the investor in the ESG factors depicts the view that the issues of ESG, including opportunities and risks, can affect the issuers’ long-term performance and must be given a suitable consideration in the decisions of investment. The ESG investing is the term that could be interpreted in different manners. It is referred as an umbrella term, a term that involves any strategy of investment, which is created on the social impact of the products or services of an entity, the governance structure of an entity, or the environmental impacts. It is an approach, which seeks to incorporate the ESG factors into the allocation of asset and the decisions of risk, so as to create long-term sustainable financial returns. The interest of investors in the ESG investing has been thriving, and has highly increased during the 2020 covid-19 crisis[2].
The supporters of ESG and some literatures covering the investment strategies of the ESG are continuously arguing that the ESG has attained its aim of gaining high risk-adjusted returns that in its technical term is referred as alpha (α). Although ESG has already been under some level of investigation relating to its association with the performance, there has been significant number of the research studies that has find the positive link between the performance of the ESG and the financial performance. The research by Ioannou and Serafeim (2014), found that the high sustainable entities outperform the low sustainability entities in the stock market terms and the accounting performance [3].
The active investors of the stock market, who traditionally used to manage their portfolio mainly depend on two important sets of the information to make the strategies of investment, which are fundamental information that heavily depend on the entity’s financial statement; and the technical information that can be derived from the entity’s past stock markets’ performance. Although these two kinds of information have been quite helpful for the investors to make the investment decisions for ages, the extensive availability of these data and technology for processing the data has become quite challenging to make superior performance in the above market returns. Along with the technical and fundamental information that mostly signifies an entity’s past performance, the information of ESG now present itself as the added set of the intelligence, which can also help in providing key knowledge of the future performance of a stock[4].
The understanding of having an added set of information that can affect the way an investor prepares his or her portfolio, in a manner that might create an alpha, could not leave an investor in an apathetic situation. Hence, this paper aims to answer and analyze the question that “Does ESG (Environmental, Social, and Governance) alpha exist?”. This paper will focus on the degree to which approach of the ESG incorporates the forward-looking information into the risks and returns’ expectations, and the degree to which it can assist in making long-term returns.
ESG Investing
Generally, sustainable finance is the process of taking into consideration the ESG factors when taking the decisions of investments, which leads to the increased long-term investments into the sustainable financial projects and activities. Its increased growth has been mainly driven by the investors’ desire to have social & environmental impact, along with the financial performance of investing. In recent years, ESG investing has been evolved to meet the increasing retail and institutional investors’ demand, who desires to better incorporate the long-run financial risks as well as opportunities into the processes of their investment decision-making to produce long-term value[5].
Over the past few years, a considerable amount of attention has been given to the criteria and investing of the ESG because of at least 3 main factors. The first factor is that the recent academic studies and industry suggest that the ESG investing, under certain situations, can help in improving the risk management and lead to the returns, which are not less than the returns gained from the conventional financial investment. However, there is increasing awareness regarding the complexity involved in the measurement of the ESG performance. The second factor is increasing societal attention regarding risks from the change in climate, the requirement for diversity at the workplace and on boards, and benefits of the globally-accepted standards of the responsible business conduct, recommends that the societal values will essentially influence the choices of consumers and investors, may increasingly impact the performance of corporates[6].
The third factor is growing momentum for financial institutions and corporations to move away from the risks and return’s short-term perspectives, for better reflecting the longer-term sustainability in the performance of investment. In this way, some of the investor desires to improve the long-term returns’ sustainability, and others may desire to include much more formalized alignment with the societal values. Hence, in either of the cases, the evidence shows that the finance sustainability should include broader external factors, so as to maximize profits and returns over the long-term period, while lessening propensity for the controversies, which erode the trust of stakeholders.
In light of increasing demand for the ESG investing, the financial industry has geared up and creating an increased number of the products and services related to the ESG ratings, funds, and indices. The entities calling themselves the providers of ESG ratings have now multiplied. There is continuous expansion in the number of ESG indexes, fixed income funds and equity, and ETFs. The investors are now be able to engage in the ESG investing with the help of low-risk products, for instance, passive smart beta ETFs and money market funds, and can also take positions through the hedge funds, which include advanced sophisticated synthetic strategies with the ESG alpha investing. The investor who intends to place themselves for a change to the low-carbon economy, can go ahead and invest in renewables and green transition funds. In regard to this, the financial markets have been proven quite agile in responding towards the demand of investors in a customer-oriented and transparent manner[7].
Figure 1: Investment in ESG through Strategy
The analysts group the ESG investment strategies into of the 5 different categories, which are impact that seeks social or environmental outcomes and often undertaken by the private investors; engagement that comprises direct communication between companies and investors; thematic that focuses on the theme, such as energy transition or water scarcity; integration that considers ESG-related opportunities and risks; or negative scree that excludes certain industries[8].
The new ESG investing modes emerged during 2000s. For instance, funds directed towards the natural resources’ protection or innovation in the low-carbon technology, but in the present situation, light green ESG investing is the most popular approach. These new vehicles of investment were based on the assumption that the data of ESG could facilitate the portfolio managers to pick the high future return’s stock. For the stock’s selection, the new light green strategies used the commercially available rankings of ESG and computer algorisms to select the stocks. The more automated approach permitted a wider variety of the fund kinds to claim to incorporate ESG data and facilitated the class of asset to scale quickly[9].
The opportunity of creating alpha with lower planetary impact and beta, has proven to be highly effective way of marketing funds. In the last two years, there has been increase in the inflows to the light-green ESG funds by twice that the rest of the stocks. Over the past few decades, the asset managers have increased the overall number of ESG funds by around 5 times, for getting in on the boom, and aggressively rebranded and repurposed the traditional products into the sustainable offerings. The wide-ranging investment vehicles of the ESG can be managed passively or actively, and might put focus on the different characteristics, such as carbon emissions, resource intensity, governance criteria, or gender diversity. The funds might also include a conventional form of investing, for instance, value or growth with a specific focus on the ESG. Nevertheless, differences in the approaches stated, various ESG funds mainly end up with the similar holdings[10].
Figure 2: Funds, Focus, and Holdings
The ESG investing also comprises some downside risks and controversies, which is having the potential to negatively affect the value of equity and increase the credit risk over the period of time. It purposes to combine risk management with the improved returns of the portfolio, and to show values of investor and beneficiary in the investment strategy. In this particular respect, the community of investment consider ESG as an approach of investment, which seeks to incorporate more consistent and greater information relating to the material social, environmental, and governance developments, opportunities and risks, into allocation of risks and decisions of risk management, so as to make long-term and sustainable financial returns[11].
There are four main arguments made about the ESG performance, which are generating higher profits; attracts investment flows; lowers the costs of capital; and signals higher returns of the stock.
Most of the analysts argued that the entities with the higher ESG performance have a tendency to deliver the higher profits. They proposed different mechanisms, but they commonly argued that entities with green attributes such as a progressive approach or a good governance to a human capital, could retain and attract the high-caliber employees. There are many portfolio managers who stated that the entities with the high scores of ESG are more eco-efficient and hence, make better gross margins, while there are others who believes that the consumers desire to switch to, or pay more for more sustainable products, by doing so, facilitating high-ESG entities to increase revenue and take the market share from the competitors[12].
The higher profits do not essentially lead to the excess returns if the price of stock already comprises these profits’ expectations. Investing in an entity that is well-managed or the one having high growth rate does not convert into higher returns, if the market is pricing already in the growth and management. For creating a portfolio that will produce alpha, the managers should have the information that the entities’ future returns will be higher than what is commonly believed.
The private information regarding an entity can help in providing an investment advantage. If the data of ESG help the fund managers with the information, which is otherwise tough to get, it could lead to the benefit when making a choice of the investments. Most ESG data, in case of the light-green funds, comes from the ESG data’s commercial providers, including Refinitiv, MSCI, and Sustainalytics[13]. All these providers use the historical information, sometimes from the public sources, so to establish measures of the corporate vulnerability to the factors of E, S, or G. The fund managers themselves stated the biggest issue with this particular approach. The data of ESG are widely available, which makes it quite tough for any particular investment fund to get a competitive edge by only using data. Further, various sources have questioned the ESG data quality. It is likely that the fund managers of ESG have created the proprietary authorisms for data processing to determine the opportunities of investment, but the initial work using the machine learning to determine the predictive elements in a popular source of the ESG data have found no any reliable patterns[14].
There are various ESG fund managers who argued that highly rated ESG entities are better regulatory, operational, and reputational risks managers. Such entities might use the climate modeling tools for the choices of plant location, lessen their risks relating to the supply chain, or better prepare for the pending regulation. As per the investment practitioners, consequently, such entities will be logically conferred a lower cost of capital, which eventually raises their valuation. Some investment practitioners argues that the high ESG entities are expected to be the better risk managers. In addition, as per the financial researchers, the belief that the lower cost of capital results in the higher returns needs backward logic. In case, the investors provide entity with the capital below its overall fair-market price, they will likely to get a lower future return, which is just contrary to the promise made by promoters of the ESG investing[15].
Some of the fund manager believes that the investment capital flow itself could result in higher returns. Around $20 trillion flowed to the ESG assets over the last 3 years. These increase in flows demands highly-rated ESG entities, thereby increasing the prices of assets. There is quite less reason to doubt that the money that flow into investments can increase the prices for a time being, by doing so permitting the early investors to accumulate the higher number of returns. However, the increasing prices can give a layer authenticity to the strategy of investment. In this particular way, there is a formation of the stock bubbles and this can be easily seen with the ESG investing. Sometimes, the market bubbles continue until any contrary evidence reverses the process of feedback, which results in a threat of losses speed up the sell and drives the prices lower. Meanwhile, the research indicated that increasing capital supply to the sustainable entities push up their prices of stock and lower their returns of future[16].
The nature of the ESG investing makes the empirical research quite tough, and it will likely hamper the consensus for some time for the number of reasons, which are stated below:
There is no any standard definition of what comprises good ESG. As an outcome, the studies and funds provide the mixed outcomes depending upon the way each defines the ESG. Although the study of materiality examined the relationship that between changes in the ESG and performance of the stock within the same entities, the other studies have compared performance of the equity between entities. The ESG have been defined by using the measures that comprises rankings from the employee happiness, ratings service, lawsuits incurred, generation of waste, and carbon emissions. Meanwhile, absence of ESG ratings’ regulation and proper auditing of the ESG reports of corporates results into fund washing spoiling the consistency, utility, and validity of research[17].
The entities’ assessment of the ESG ratings are mainly based on the extrapolation, incomplete data, and subjective data. The ESG data provided by the entities are most often unaudited, self-reported, and old. The previous ratings are believed to be backdated to fit the subsequent performances. The ESG ratings wildly differs by different analysts.
There are various studies that report the outperformance of ESG, are incorrect and are mainly based on the short-time horizons, which are not significant statistically. The omission of the required risk adjustments and choosing a current period with the upward shifts in attention facilitates documentation of the outperformance, which actually there is none. There are 4 ESG-themed strategies (impact investing, green revenues, ESG integration, and exclusively screening) that can be used to determine a relationship between the ESG and alpha. Most of the research affiliates in the academic and traditional senses believes that the ESG is not the equity return factor[18].
Lastly, there is a positive relationship between the high-ESG entities and alpha that may result from the correlation and not causation. Since valuation relies on various factors, it is not possible to credit financial performance to any particular factor. For instance, it may be the case when both equity returns and ESG are a function of the management’s quality[19].
The investment community has started to realize that the ESG and generation of alpha is not mutually exclusive. The research indicates that in some cases comprising the ESG conscious entities in the portfolio can be additive and provide downside protection. The entities having high rank on the ESG metrics have indicated an ability of delivering above-market returns. Another likely benefit of taking into consideration the sources of ESG alpha is that the high ESG-rated entities have a tendency to of having lower exposures to the company-specific and systematic risk factors that leads to the lower cost of capital ad well as long-term valuation under the framework of DCF. There are various other channels of relationships between alpha and the ESG that are being discovered, and documentation of such connections is continuously increasing by the researchers and industries[20].
There are various light-green strategies of investment that do not even try to deliver alpha. Further, there are some more than portfolios of market that are branded with the different names, such as the 3-year old Vanguard ESG US Stock ETF is having a correlation of 0.9974 to the S&P 500. The correlation-1 implies a perfectly sync funds. It is quite tough to imagine the way such funds could outperform the market consistently.
It is quite possible that some of the investment strategies of ESG may create alpha, such as, although strategies are employed less often than ESG integration or negative screening, engagement appears to be quite promising path to beat the market. One engagement research study at 613 public entities, which were the activist investor’s target focused on improving the practices of ESG. This found that there are positive excess returns in around eighteen percent of the engagements, where activism succeeded[21]. It is an ironical that this is a same kind of investing that was initially employed by the positive-scree funds, invested only in the socially responsible entities around twenty years ago. The next strategy of ESG, which might help in delivering alpha in early investing on the entities that are poor ESG entities but are on its path of improvement. The studies by Bernstein and Rockefeller Capital Management found in their study that the best ESG improvers beat the worst group of the ESG decliner during the 10-year period from 2010-2020. Further, in some cases, the fundamental analysis aimed to find out the entities, which stand to gain from the increased regulatory pressure of the environment or a shift in the behavior of consumer has also proven to be a successful and winning formula [22].
However, most of the ESG investing is a trick to maximize fees, launder reputation, and lessen guilt. This also results in creating a false hope and expectations, oversell its capacity of outperforming the market, and probably contributes towards delaying long-past due regulatory actions. Hence, the growth in using ESG ratings, disclosures, and different kinds of the ESG-related funds has necessitated greater level of scrutiny from a wide range of the market practitioners. Further, there is increasing awareness from the finance industry that the practices of ESG investing require to develop to meet up its users’ expectations and to sustain their trust level. There are different regulatory bodies, such as TCFD, SASB, and GRI are now highly involved in the assessment of the ESG information’s use and consistency, its materiality across different industries, and the way this information needs to be scored and prioritized[23].
Conclusion
Therefore, it can be concluded that despite various limitations, the scoring and reporting of ESG has a great potential of unlocking a significant portion of information on the companies’ management and resilience when seeking for the long-term creation of value. It could also signify the important mechanism based on market to assist the investors to better align their portfolio with social and environment critical, which aligns with the sustainable development. The analysis of the wide variety of approaches and metrics contribute to the outcomes that adds to a wide range of the investment practices of the ESG, which in comprehensively, arrive at the consensus of industry on the high-ESG portfolios’ performance that may continue to be open to the interpretation.
Yet, the progress to reinforce meaningfulness of the ESG investing highly calls for higher efforts towards consistency of metrics, transparency, alignment with the financial materiality, and comparability of the ratings methodologies. Nevertheless, efforts by the standard setting bodies, regulators, and private sector participants in the different regions and jurisdictions, and global guidance may be required to ensure integrity, resilience, and market efficiency. As far as investing is concerned, one must keep in mind that the entities that will make the highest returns must be the first priority. It is the primary goal of an investor, but entities that show exceptional sustainability must also outperform the overall competition, as they are better at management of their resources. As a critical thinker, a stock picker, and an independent thinker, an investor must make a wise decision when it comes to investing money; they must look at the overall performance both financial aspects and sustainable aspects. Based on which, they should take decision that whether investment can be done or not.
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