Practical analysis for investment professionals
16 September 2020

The ESG Performance Paradox

The US Department of Labor’s recent actions have cast a spotlight on the curious logic underpinning the case for environmental, social, and governance (ESG) investing.

More than 8,700 commenters wrote in July largely to condemn a new rule proposed by the DOL that would limit the ability of most employee retirement plans to select investments based on ESG factors. But the DOL’s move is well-founded, and it’s not surprising that many of the scathing critiques, accusing the DOL of everything from perpetuating racism to submitting to political interference, came from active fund managers.

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The truth is, ESG is such a broad and haphazard concept that without strong fiduciary standards, it risks becoming a convenient excuse for those same fund managers to underperform their benchmarks while also charging higher fees.

ESG proponents often spin a win–win narrative, wherein corporate behavior aligned with certain values and practices also leads to better financial outcomes and investment performance. Yet like all complex issues, the reality is not so clear: Difficult decisions frequently arise when balancing the objectives of financial gain and social responsibility.

Psychologist Philip Tetlock terms uncomfortable situations like these “taboo tradeoffs”: Whether we admit it or not, socially responsible investment choices will sometimes come at the cost of financial returns. At the crux of the DOL’s intervention is whether it is appropriate for plan sponsors to attempt to make those tradeoffs on their beneficiaries’ behalf.

The upshot: In the coming months, ESG integration practices could become the newest battleground in the growing tsunami of Employee Retirement Income Security Act (ERISA) breach lawsuits against fiduciaries.

The argument that ESG factors lead to better long-term performance outcomes is much harder to prove than we might imagine. Academics have found a surprisingly low correlation between ESG ratings across providers. In other words, experts can’t even agree on which firms have solid ESG credentials in the first place. Part of the problem is that the ESG umbrella encompasses so many different issues, whose salience is continually shifting.

Ad tile for ESG and Responsible Institutional Investing Around the World: A Critical Review

Such so-called sin stocks as tobacco and defense — which, incidentally, have beaten the broader market over the long term — were the original ESG castaways. Then for most of the last decade, ESG became nearly synonymous with combating climate change and measuring carbon footprints. Today, firms and investors are racing to compile metrics and scorecards on diversity and inclusion, which have rapidly moved to the top of the ESG agenda.

Let’s assume for a moment that these measurement issues and taboo tradeoffs didn’t exist, that ESG exposures could be accurately identified and exerted a positive impact on corporate financial performance. A second and even more difficult question then arises: To what extent is this information already incorporated into asset prices?

If ESG credentials are already priced into stocks, then the best investment strategy may actually be to buy the worst performers on ESG measures. To see why, consider that private equity firms don’t seek out the best-run companies to acquire. Rather, they often target firms with serious operational problems because those companies have the largest potential value uplift if improved.

Likewise, today’s ESG “laggards” are likely to face increasing pressure to reorient and improve themselves over time. If improving ESG credentials indeed augur better financial results, then these laggards could prove the best investments at today’s prices. This is another reason that structuring investments around strong ESG performance could have adverse financial consequences.

Ad for Sustainable, Responsible, and Impact Investing and Islamic Finance: Similarities and Differences

Fast forward to the long run — which economists are quick to point out never arrives — and assume that there’s no more adaptation, and firms have all reached their steady-state ESG statuses. Even then, we would still expect firms with poor ESG credentials to outperform on average. Financial theory states that in order to bear the financial risks (and social stigmas) of holding these firms, investors would require higher returns. That’s the flipside of the argument that embracing ESG can lower a firm’s discount rate: The lower the capital costs to the firm, the lower the rewards to its capital providers.

In sum, the DOL should not bow to criticism from vested interests for simply doing its job and attempting to ensure that workers attain the financial security they need to retire comfortably.

If ESG proponents are so confident in the win-win impact of ESG on performance, they should have no qualms with a regulatory requirement that this relationship actually be true.

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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.

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About the Author(s)
Jordan N. Boslego, CFA

Jordan N. Boslego, CFA, is an environmental, social, and governance (ESG) researcher and co-founder of Empirically, a provider of predictive analytics and litigation support regarding investment manager selection.

5 thoughts on “The ESG Performance Paradox”

  1. Bernard S. Sharfman says:

    Excellent post! For a comment letter that supports Mr. Boslego’s position, see

  2. Kirk Cornwell says:

    More small print. The assumption that “regulations” (MORE small print) are a solution to anything here sounds like my friend Senator Warren. At best, “ESG“ is subjective and there is no reason not to accept some level of underperformance until the rest of the investing world is on board.

    1. jesus arguelles says:

      Mr. Boslego, you highlight well key pros and cons of applying ESG filters in investing decision-making to optimize portfolio performance in the short, middle and long term via capital allocation and cash flow. Presenting both sides of ESG investing in the context of DOL’s decision based on a fiduciary rationale is good for purposes of defining and clarifying what ESG investing is and its apparent, emerging limitations (paradox? Am not clear on this based on your reasoning) given its historical policy and regulatory framework.

      On the other hand, given all the downsides of using ESG screens (such as confusing it with socially responsible investing, existing conflicting definitions by practitioners , selecting the appropriate ESG indicators, challenging risk management scenarios and modeling, using classical investment theory, measuring and reporting correctly and timely social and environmental impacts , etc.), the ESG approach remains as the only viable and gradual, and admittedly incremental acceptance, in measuring and holding accountable U.S. corporate and institutional investors of their responsibility to society to do good while monetizing the externalities of our market-based economic system in an equitable and inclusive manner by maximizing stakeholder value. Note: Dr. Friedman’s view and work aimed at maximizing stockholder value as being the sole purpose of an enterprise is out of date and was only relevant for a short period of time when communism and socialism were the 800 lb gorilla in the room and inclusiveness, diversity and equity were but words in our lips instead of embedded in our group and individual psychological DNA as national, existential imperative.

      Here is an idea: Perhaps there should be an ESG Exchange which would include socially responsible companies, opportunity zone funds, investment firms offering ESG themes, equity/debt impact funds focusing on any or all of the E, S and Gs, e.g., Blackrock and securities houses offering green bonds. The Exchange would also include B companies, sustainable enterprises and others that offer services and products aimed at reducing social, environmental and governance gaps in the U.S. to begin with. Incidentally, I would add to the ESG another “E” at the beginning as such …or EESG…. so that it is clear that economic impact such job creation/retention, household incomes and net worth, business startups, community investing/lending etc. are addressed. Example: Long Term Exchange and/or the option of creating exchanges based on ethnicity, cast, gender/preference, etc. is the way to go such as the Dream Exchange.

      Bottom line: We must begin to think and do out of the box NOW. New investment paradigms need to be created to reach the goal of accelerating the presence of institutional justice culture and an economically equitable society. Is ESG the only vehicle to get there? Definitely not! However, for now, that is all we have until ESG becomes a well-established, non-correlated investment class from its present $34T to over $100T by 2025 instead of within the next 10 years!

  3. Antonio Vives says:

    The discussion on the over, under or equal performance of ESG versus the market or vice funds is impossible to show as the term ESG, as of today, cannot be defined with any reliability. It is whatever you want it to be. If you have a little E, but lousy S and G, you are still labeled ESG. See my article Are your ESG investments “sustainable grade”? in

  4. Jim Hamilton says:

    This is a very good paper but it is two years old and doesn’t appear to be related to other content in this email publication. Since it was published there has been a massive reassessment of the entire concept and in particular whether for fund managers it is a breach of fiduciary duty. Attorney Generals in 19 States appear to believe it may be.

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