Practical analysis for investment professionals
14 January 2019

ESG Investing: Too Good to Be True?

Good vs. Bad Corporates

BlackRock is aggressively launching products with high environmental, social, and governance (ESG) ratings. The firm’s CEO, Larry Fink, recently predicted that assets under management (AUM) in the ESG category will grow from the current $25 billion to $400 billion in 2028.

Investing in good corporates is intuitively appealing. Who doesn’t want to make money while doing good? But do stocks that rank high on ESG metrics actually outperform? After all, sin stocks — think gambling, alcohol, tobacco, and firearms — generate above-average returns, according to research. It would be a bit paradoxical if ESG and more-virtue-challenged factors both outperformed. For insight into these issues, we explored ESG factor performance in the US stock market.

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We explored ESG data from a US provider that aggregates ESG scores from multiple sources. Using data dating back to 2009, we divided ESG stocks into four main groups: Citizenship, Environmental, Employees, and Governance. Next, we created beta-neutral long-short portfolios composed of the top and bottom 10% of US stocks as ranked according to these four factors. We only included companies with market capitalizations in excess of $1 billion. The resulting portfolios are rebalanced monthly and include 10 basis points (bps) of cost per transaction.

ESG Factor Performance in the United States    

Except for the Employees factor, all ESG categories generated positive returns from 2009 to 2018. Based on these results, being a good corporate would seem to pay off.

ESG Factor Performance in the United States

Source: FactorResearch

Are ESG Factors New?

But ESG factor performance shares some common trends, so the underlying portfolios likely have overlapping stocks. This is fairly logical. Companies that care about the environment, for example, may show similar regard for corporate governance and their employees.

For more insight into the drivers of ESG factor performance, we conducted a factor exposure analysis. We found that ESG factors are biased towards common equity factors. Of particular note are the negative exposures to both the Value and Size factors as well as positive exposures to the Low Volatility and Quality factors. The R-squared calculations of the regression analysis from which the factor betas are derived average 0.5, implying that the common equity factors explain the performance of the ESG factors reasonably well.

Factor Exposure Analysis (Factor Betas), 2009–2018

ESG: Factor Exposure Analysis (Factor Betas), 2009–2018

Source: FactorResearch

The negative exposure to the Value factor suggests that stocks with high ESG scores have higher valuations than their less-conscientious counterparts. One possible explanation for this is that cheap stocks face temporary or structural issues that make achieving high ESG scores less of a priority for the companies.

Average Price-to-Book Multiples, 2009–2018

ESG Factors: Average Price-to-Book Multiples, 2009–2018

Source: FactorResearch

Smaller companies also have fewer resources. Indeed, the average market capitalization of the top 10% of the highest-ranking ESG stocks is almost twice that of the bottom 10%.

Average Market Capitalizations (US Billions), 2009–2018

Average Market Capitalizations (US Billions), 2009–2018

Source: FactorResearch

Stocks with high ESG scores also display strong positive exposure to the Low Volatility factor. So lower-ranked stocks may be more volatile. There doesn’t seem to be an easy explanation for this, though it may reflect biases to certain sectors of the stock market.

Average Betas, 2009–2018

ESG Factors: Average Betas, 2009–2018

Source: FactorResearch

The positive exposure to the Quality factor, which we define as a combination of debt-over-equity and return-on-equity, has a simpler explanation: Less-levered companies tend to have management with a more long-term perspective, and highly profitable firms have more resources with which to achieve high ESG scores.

What Has Been Driving ESG Factor Performance?

According to the analysis thus far, ESG factors generate positive excess returns. Good corporates pay off, in other words, which would seem to be good news for all investors.

However, this performance may be a product of exposure to common equity factors. The ESG factors exhibited negative exposure to the Value and Size factors, which both generated negative returns since 2009.

More importantly, ESG factors had large positive exposures to the Low Volatility and Quality factors. The Low Volatility factor was the best-performing factor since 2009 and accounts for much of the positive excess returns derived from ESG factors.

Selected Equity Factors in the United States

Selected Equity Factors in the United States

Source: FactorResearch

Changing the Perspective

The factor lens is just one way through which to view the ESG factor puzzle. What does a sector analysis of companies that rank high and low on citizenship look like?

It turns out there are large sectoral biases. This is hardly a surprise. Energy stocks tend to have low citizenship scores. After all, oil-fracking companies in the United States are more associated with earthquakes than friendly community engagement.

How does the breakdown by sectors reconcile with the factor exposure analysis?

The negative exposure to the Value factor is reflected in the significant overweight in technology stocks, which trade at higher valuations. Tech companies also tend to have less debt and high profit margins, which explains the positive exposure to the Quality factor. Finally, the positive exposure to the Low Volatility factor can be reconciled with an underweight in sectors like Energy and Materials, which are more volatile than the average stock.

Citizenship ESG Factor: Breakdown by Sectors

Citizenship ESG Factor: Breakdown by Sectors

Source: FactorResearch

Further Thoughts

The notion that companies that care about the environment, look after their employees, and exhibit good governance outperform is likely too good to be true.

The drivers of performance since 2009 were common equity factors. While factor exposure might change over time, ESG investors currently run the risk of missing out if small and cheap stocks start outperforming low-risk and high-quality stocks.

Historically, speculating on small and cheap stocks hasn’t been a bad bet. That may be true again.

For more insights from Nicolas Rabener and the Factor Research team, sign up for their email newsletter.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©Getty Images/

About the Author(s)
Nicolas Rabener

Nicolas Rabener is the managing director of FactorResearch, which provides quantitative solutions for factor investing. Previously he founded Jackdaw Capital, a quantitative investment manager focused on equity market neutral strategies. Previously, Rabener worked at GIC (Government of Singapore Investment Corporation) focused on real estate across asset classes. He started his career working for Citigroup in investment banking in London and New York. Rabener holds an MS in management from HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km Ultramarathon, Mont Blanc, Mount Kilimanjaro).

7 thoughts on “ESG Investing: Too Good to Be True?”

  1. James Ware says:

    It’s a fair question: do ESG stocks outperform? But that misses the point for many. I will invest in ESG regardless because I want to support firms that are good corporate citizens. if the return is the same or slightly lower than the relevant index, I don’t care! that’s the point. My value system ranks “doing good” over “doing well.” Read my book, “Money, Meaning, and Mindsets” for more on this topic.

    1. Norbert says:

      I completely agree. The question, whether ESG Factor Investing has the intended effect of improving our world at all is much more relevant. The strong forces towards increasing market efficiency would counteract, as can be seen from other factor Investing. For example, Value Investing looses its outperformance rapidly since detection. Why should the ESG factor behave differently? If not so, market forces would take care of even capital allocation to the ESG as well as to the sin factor.

  2. Ben Yeoh says:

    “We explored ESG data from a US provider that aggregates ESG scores from multiple sources.” This methodology has a serious weakness. Unlike eg “momentum” or “value” factor. There is no agreed definitions of an “ESG” factor (see also Axioma ESG research looking at idiosyncractic vs common ESG factors).

    And so, this study doesn’t answer the question posed at all.

    Indeed, you can see why theoretically many so-called “ESG factors” might be idiosyncractic and stock-specific and go in to the large “residual” quant bucket.

    For instance, CEOs and fundamental investors typically agree that “corporate culture” is important for “value creation” and that this may fall across a “S” or “G” dimension. But there is no well defined “culture factor”. Indeed arguably most culture is stock-specific.

    For full disclosure the ESG data provider should be named and also the underlying sources, and also whether this analysis has undergone any other peer review or not.

    I comment in a personal capacity.

    1. Hi Ben, I think you’re making a lot of valid points and more research on ESG is needed. We wanted to name the data provider, but after seeing the slightly negative results on ESG, they asked us to remove their name as selling ESG data represents their business.

      However, most of the results are kind of intuitive and are likely to be verified by other researchers. Companies that rank high on ESG are more probable to come from the tech than the energy sector given structural industry differences. Sectoral biases lead to factor tilts.

      Taking a further step back: Companies that rank high on ESG need to fulfill the requirements of stakeholders, not just shareholders, which consumes resources where the benefit for shareholders is debatable. Investing in ESG should not be seen as a potential source of alpha from our perspective, but more a personal preference.

  3. Iaroslav says:

    Sell-side professionals are trying hard to invent something new to offer common public. Pursue of brokerage fee is the reason for such kind of inventions. Good luck!

  4. Peter says:

    This analysis and the research behind it is deeply flawed:

    – Small sample size (not even 15 years)
    – No adjustment was made for risk differentials between Standard and ESG approaches.
    – The fact that the ESG approach “slightly” underperforms (no delta is given) confirms, if anything, that the analysis is inconclusive.
    – Author is openly biased against a stakeholder governance approach.
    – Fact: More than 90% of the over 2200 academic studies that have looked at ESG factors have positive findings.
    – If you want well-balanced, candid ESG analysis from an undisputed ESG expert, check out Mary Jane McQuillen, featured in the Dec-5th-2019 Enterprising Investor.

    Very disappointed that the CFA Institute would publish this type of analysis on its letterhead.

  5. Peter says:

    For more perspective on Nicolas Rabener’s views when it comes to ESG, see this this link:

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