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ESG Investing: Don’t Forget Factor Exposures

Any benefit from incorporating ESG credentials into a portfolio is already captured by other well-defined equity factors.

An important question for investors in environmental, social and governance (ESG) investment strategies is: What is the impact of ESG strategies on expected returns? Should they expect higher or lower returns from their investments compared to non-ESG equivalents? Fortunately, there is a large body of research that provides consistent answers.

In our book, Your Essential Guide to Sustainable Investing, Sam Adams and I presented the evidence from research (including studies from 2017, 2018, 2019, 2020 and two from 2021) that found:

  1. In both U.S. and international markets, ESG strategies’ returns were well explained by their exposures to the Fama-French factors of market, size, profitability, investment, momentum and value—multifactor alphas were not significantly different from zero;
  2. While most of the returns of “green” and “brown” portfolios were explained by exposure to common equity factors, the return patterns varied as factor exposures changed from low- to high-scoring portfolios;
  3.  Investors could not improve their Sharpe ratios by using ESG strategies;
  4. Return and risk differences of ESG funds could be significant and were mainly driven by fund-specific criteria rather than by a homogeneous ESG factor. For example, some funds had a large-cap focus and others a growth or value focus. In addition, there were differences in industry concentrations (which led to large dispersions in returns);
  5. Across four fund categories (index, active, exclusion based and non-exclusion based), the majority of observations displayed higher volatility than the broad market. This finding is not surprising because, by definition, ESG funds are less diversified than the market;
  6. ESG companies tended to be larger, with other factor loadings and alphas tending to cluster around zero. However, for active funds, the share with positive alphas declined over time; 
  7. The environmental and social scores did not contribute to performance—the positive benefit of the governance score was well explained by its correlation to the profitability factor; and
  8. Firms with high ESG scores had better risk management and better compliance standards, leading to fewer extreme events, such as fraud, corruption and litigation (and their negative consequences). The result was a reduction in tail risk in high ESG scoring firms relative to the lowest ESG scoring firms. The highest scoring ESG firms also had lower idiosyncratic risk and lower expected returns.

The authors of these studies all concluded that 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 (or lower) risk-adjusted returns. However, the evidence also showed that if ESG investors are willing to tilt their portfolios to those sustainable firms with exposure to the Fama-French factors of size, investment, profitability, value and momentum, they can have their cake (earn higher expected returns) and eat it too (express their social views). Dimensional, as one example, has a suite of sustainability funds that tilt to the size, value and profitability factors.

Latest Research

The recent study “ESG Equity Index Investing: Don’t Forget about Factor Exposures,” authored by Jan-Carl Plagge, Marvin Ertl and Douglas Grim and published in the Winter 2022 issue of The Journal of Beta Investment Strategies, explores whether ESG strategies have common exposures to well-known sources of risk stemming from so-called style factors. Specifically, they investigated the extent to which the factors of size, value, profitability, investment and momentum drive the performance of investable index-linked ESG equity strategies in the U.S., European, Asia-Pacific ex-Japan, Japanese, and global developed and emerging markets from 2013-2021. Over that period, the overall number of funds increased from 54 to 343 and total assets grew from $13.4 billion to $416.3 billion. Here is a summary of their key findings, which are consistent with those of prior research:

A factor-based return decomposition of a global sample of ESG equity index strategies revealed that their performance was largely driven by well-known traditional sources of risk—there was only limited evidence for the existence of an independent ESG-related factor (there was no statistically significant evidence of an ESG alpha).  The market factor frequently contributed most to total risk (87% on average) across all regions. Market beta was basically 1 across regions. There was variability in the exposure to, and influence of, the factors explored, both within and across regions as well as over time. For example, exposure to the profitability factor was negative in Asia-Pacific ex-Japan and Europe but positive in the U.S, and exposure to the value factor was negative (at the 1% confidence level) in Europe but not elsewhere. 

Among style factors, the negative exposure to size (an average of -0.16) was the most common statistically significant (at the 1% confidence level) fund-level tilt, which likely could be explained by the greater financial capacity of large firms to address ESG-related challenges and risks. Larger companies also face increased pressure from investors, analysts and the media with regard to ESG disclosures and improving on any disclosed deficiencies. There was significant dispersion in the persistence, sign and statistical significance of factor exposures as well as alphas across individual funds in our sample—investors should not assume the existence of common style factor exposures or even an independent ESG-related factor across ESG investment strategies.

Their findings led Plagge, Ertl and Grim to conclude: “Investors should form an opinion not only as to whether they expect a specific ESG index strategy to have a (factor-adjusted) positive or negative alpha, but also whether they expect it to exhibit any persistent factor tilts and whether such tilts may help or hurt long-term absolute performance.”

Investor Takeaways

Sustainable investment strategies that do not take into account factor exposures should expect lower returns. However, sustainable strategies also reduce risk. Thus, there may not be a sacrifice in risk-adjusted returns. In the short term, the increased demand from sustainable investors might even be sufficient to offset the ex-ante lower expected return as valuations of green stocks relative to brown stocks increase. However, once a new equilibrium is reached, lower returns and lower risk should be the expectation. And markets are becoming more efficient, quickly incorporating information about sustainable risks into prices. The lower expected returns can be offset by increasing exposure to factors with higher expected returns (such as size, value, investment, profitability/quality and momentum).

Yet, evidence from studies such as “Do Investors Value Sustainability? A Natural Experiment Examining Ranking and Fund Flows” has found that mutual fund investors, both individual and institutional, collectively treat sustainability as a positive fund attribute, allocating more money to funds awarded five Morningstar globes and less money to funds with only one globe.

If investors want to make sustainable investing a core of their philosophy, thorough due diligence is required before committing assets. It should not only include the screening methodologies but also a careful examination of factor loadings, industry concentrations and expenses. Due to the wide dispersion of outcomes caused by systematic differences in portfolio holdings, investors are best served by assessing investment implications of sustainable strategies on a fund-by-fund basis. For those investors with sufficiently large investable assets, there are separately managed account providers that will build individually tailored portfolios (which provide the added benefit of tax efficiency). 

Larry Swedroe has authored or co-authored 18 books on investing. His latest is “Your Essential Guide to Sustainable Investing.” All opinions expressed are solely his opinions and do not reflect the opinions of Buckingham Strategic Wealth or its affiliates. This information is provided for general information purposes only and should not be construed as financial, tax or legal advice. 

TAGS: Mutual Funds
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