ESG is not an equity factor, but investors’ preference for this style of investing means these strategies could outperform, according to a new white paper by Research Affiliates.
In the paper, the US-based firm defined a factor as a ‘characteristic associated with a long-term risk-adjusted return premium,’ such as classic ones like value, momentum, size, quality and low volatility.
The authors said these factors’ excess returns come from either extra risk or behavioural bias. For example, value stocks have lower profitability and often more leverage. Incurring those greater risks means investors deserve a premium or greater return.
The behavioural argument is that investors have under-priced admittedly inferior value companies too much and over-priced superior growth companies too much in a dual overreaction. Once the value companies perform better than expectations, and the growth companies worsen, a mean reversion of their prices occurs.
Where ESG differs
Research Affiliates noted that ESG does work in the same way, but added that recognised factors have a long history of academic research and back testing behind them, whereas ESG does not.
Factors also exhibit robustness with variations. So, for example, value can be defined as low price/earnings or low price/book value or some combination of these two metrics and others like price/sales. But ESG has no similar standard definitions across which it has demonstrated robustness.
The acronym ESG itself has distinct components, each of which may capture many different themes and metrics. Indeed, there is a lack of consistency among ESG ratings, some of which may rate a particular company well and others not well.
Still, Research Affiliates allowed for the fact that ESG may out-perform in the future despite not meeting a strict factor definition. One reason for that is there may be risks inherent in companies that rate poorly on ESG metrics.
Climate change, for example, may force economies away from carbon based fuel. Coal is a carbon-based fuel whose use has already declined dramatically.
It added that investor preference may support ESG strategies in the future. The shift toward ESG is currently occurring in two main groups taking a larger share of household assets: women and millennials.
Research Affiliates cited a Bank of American study discussing this transition, and arguing that $20tn of assets (the equivalent of the S&P 500 today) will fuel the growth of ESG assets over the next two decades.
Greater regulatory efforts in Europe seeking to standardise ESG principles and interest among US pension funds in ESG should also fuel the growth of ESG strategies.
That means ESG doesn’t have to meet the strict definition of a factor to perform well for a long period of time. A massive, one-time adoption of ESG criteria among investors could lead to out-performance for companies who have high ESG scores.
You can read the paper in full here.