ESG InvestingOct 26 2021

Are ESG stocks really outperforming?

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Are ESG stocks really outperforming?
Photo by Felix Mittermeier from Pexels

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.

Figure 1: European high ESG outperformance is powerful over the past 8 years. Adjusting by sector does not materially change the performance.

The Investment Metrics Style Analytics Toolkit provides factor attribution of a portfolio’s outperformance, which, for the European high ESG portfolio, showed no factor dominance. However, when we included ESG as a 'factor' it jumped to the top of the list. The table below shows the top five ‘factors’ and their relative contribution, where the only factor of consequence is ESG.

FactorPerformance allocation
MSCI ESG overall39.3%
Market cap (size)7.7%
Dividend growth (five year)6.7%
Cash flow yield (value)5.1%
Low gearing (quality)4.6%

Top five factor performance attributions for the European portfolio shows that no fundamental factor explains the portfolio's outperformance. However, the MSCI ESG overall score, when treated as a factor, dominates the return attribution.

The European ESG momentum portfolio showed no outperformance on an unadjusted basis, but showed annual outperformance of 2.8 per cent after adjusting for sector allocations, as shown in Figure 2. Most of this outperformance occurred in the post-Covid rally.

Figure 2: European ESG Momentum outperformance after adjusting for sector allocations

This outperformance can be partially explained by the portfolio’s exposure to high sales growth companies and to those with low gearing (leverage), but not enough to change the conclusion that ESG momentum outperforms in Europe.

US ESG performance in detail

Before adjusting for sector allocations, the US high ESG portfolio shows an outperformance of 40 per cent over the period, about half of which happened after the Covid crash. A quarter of that outperformance is explainable by sector allocations and another quarter is explained by just one measure of quality: the ratio of gross profits to assets.

However, when we took account of sector biases in high-scoring ESG stocks and made the portfolio sector weights the same as the benchmark, all outperformance vanished.

Figure 3: US high ESG portfolio returns relative to its benchmark. The outperformance vanished when ESG stocks sector biases were neutralised, such that the portfolio has the same sector allocations as the benchmark.

The US ESG momentum portfolio shows no signs of outperformance on either an unadjusted or sector adjusted basis, as shown in Figure 4.

Figure 4: The US ESG momentum portfolio shows no outperformance over an identically weighted benchmark.

Conclusion

In the US, sector allocations fully explain any perceived ESG outperformance. The significant outperformance of European high ESG stocks compared with the benchmark-like performance of US high ESG stocks suggests that rather than being a causal factor of equity market performance (like value, size, quality, etc), ESG may just reflect regional differences in investor preference.

If ESG stocks outperform the market in Europe for no other reason than those investors preferentially buy high ESG stocks as part of an ethical investing wave and thereby drive prices up, then we might expect the same to happen in the US once that wave builds on the US side of the Atlantic.

But these regional differences do not indicate a bubble. ESG may have had its start for ethical and moral reasons, but it has been incorporated into mainstream investing and is now an attribute of stocks, much like a factor, that can form part of an investment strategy.

Damian Handzy is head of research and applied analytics and James Monroe is a senior consultant at Investment Metrics