Critics dismiss environmental, social and governance investing as a feel-good strategy unrelated to investment performance.
And they claim that any ESG outperformance can be explained by exposure to certain industries or to high-quality stocks or other investment factors.
At worst, they say ESG investing is a mirage: just enough outperformance to convince those who want to believe.
So, what does the data really tell us?
We looked at US and European stocks with high ESG scores as ranked by the MSCI ESG rating, which ranges from zero (worst ESG) to 10 (best ESG), as well as stocks with high ESG momentum (rapidly rising ESG scores) over the past eight years.
We then looked at the different factor exposures of each stock, to see if performance could be explained by something other than ESG.
The aim was to establish, firstly, the extent to which each factor is responsible for a stock’s performance, and then, having made allowances for all others, the performance that can be attributed to ESG alone.
We similarly reviewed the overlap that high-ESG portfolios might have with certain sectors (such as tech – more on that later), which could influence their performance and superficially appear as attributable to ESG. After correcting for these effects against the benchmark, we have a good idea of whether ESG outperformance is reality or a mirage.
This showed that European ESG outperformance is the real deal. High-rated European ESG stocks outperform 12 per cent annually, even when factor and sector biases are taken into account, while high momentum stocks also outperform, by 2.8 per cent, but only after biases are removed.
It is not the same case in the US, however. High-ESG-scoring stocks have a huge 40 per cent outperformance, but this outperformance vanishes when biases are removed. Meanwhile, high ESG momentum stocks show no outperformance before – or after – bias adjustment.
Europe has ESG stars, in the US it is down to sector and factors.
In Europe, the highest rated ESG stocks rewarded investors with 12 per cent outperformance a year. Even when factor and sector biases are taken into account, outperformance attributable to ESG merely improves.
High ESG momentum stocks only showed annual outperformance – of 2.8 per cent a year – after sectors and factors are taken into account.
The US is quite different. Any outperformance by high-ESG-scoring stocks can be laid at the door of sector allocation (mainly tech) and by a powerful quality sub-factor measure: high gross profits to assets.
High-scoring ESG momentum stocks showed no outperformance, either before or after biases were removed.
European ESG performance in detail
European high ESG and ESG momentum portfolios demonstrate persistent outperformance over their benchmark even after factor and sector adjustment.
The European high ESG portfolio, containing the highest 10 per cent of ESG-scoring stocks, outperformed by about 12 per cent per year. Adjusting the portfolio to match the benchmark’s sector allocation simply increased its outperformance, as shown in Figure 1.