Preface

ESG is a massive topic; in fact, so big that it is hard to give it justice in the approximately 1,500 words I have at my disposal in these monthly letters. Consequently, I have decided to split it over two months. In this first part, I will focus on performance – does ESG investing generate alpha, or is it just a fad? In next month’s part two, I will turn my attention to the impact of ESG – has it in fact changed anything? Has the world actually improved as a result of ESG?

How do we treat ESG at Absolute Return Partners?

At the very least, ESG has become a buzzword. To some, it has even become a religion.  Whether one or the other, I often wonder whether it is good or bad for performance when you comply with the principles behind ESG, and that is essentially what this month’s Absolute Return Letter is about.

Before I go there, allow me to put the cards on the table and tell you how we deal with ESG at Absolute Return Partners. Essentially, we think there is often too much box-ticking and not enough qualitative thinking going into many ESG assessments. Consequently, we take a more qualitative approach. We aim to always invest responsibly, but we admit that we are not yet where we want to be. Investing responsibly is a very complex process which takes years to refine, and we are still on that journey.

The essence of ESG investing

(This section is largely a copy and paste from an article called “How is ESG Affecting Stock Returns?”, published in 2020 by the School of Economics and Management at Lund University, Sweden.)

ESG has three pillars – the “E”, the “S” and the “G”. The first pillar, the Environmental pillar (the “E”), focuses on how a company performs as a steward of the environment. As the changing climate has become frontpage news all over the world, the “E” has, of the three pillars, been awarded the most attention by the investment community.

The second pillar, the Social pillar (the “S”), considers how a firm manages relationships with its employees, suppliers, customers and society at large. Social factors such as human rights and child labour play an important role in this context and are allocated much attention in the financial community.

The third pillar, the Governance pillar (the “G”), addresses internal issues. How does the company in question deal with issues such as executive pay, diversity, internal controls and shareholder rights? The Governance pillar is about internal affairs and not about how its behaviour and actions affect the rest of the world.

Although ESG is on everybody’s lips these days, it is not a new phenomenon. The concept started in the 1960s, when investors began to exclude certain companies or industries based on their business activities, e.g. tobacco companies. Even entire countries were excluded. Take for example South Africa which became a pariah as a consequence of the apartheid regime. In the 1970s, the “S” began to attract attention due to the use of chemical weapons in the Vietnam War, and that led to the first sustainable mutual fund.

A frequently used approach is so-called ESG scores – hence my argument that the ESG approach is sometimes too much about box-ticking. Around 1990, almost nobody published ESG scores, but that has since changed and is now a massive industry.

The changing fortunes of ESG investing

ESG investing is, or at least was, very big but fortunes are changing. According to Financial Times, only 6 ESG funds launched in the second half of 2023 compared with 55 in the first half. Earlier this year Wall Street Journal dubbed ESG “the latest dirty word in Corporate America”, and Larry Fink, CEO of Blackrock, said last summer that he would no longer use the term “ESG”, as it had become “weaponised” (source: Alex Edmans, London Business School).

Let’s spend a minute on Alex Edmans, who is one of the most active in the ESG debate on the London scene. In a series of papers on the topic, he has made many good points. Allow me to quote from his most recent paper, “Rational Sustainability”, published earlier this year: “The term “ESG” sometimes replaces clear-headed thinking by implying that it is different from mainstream business. As a result, we think that the insights from decades of research do not apply and resort to “gut feel” when practicing ESG. But if we scrap ESG, what do we replace it with? Retiring the term without changing the practice fails to address the many legitimate concerns about ESG. Abandoning the practice entirely will throw the baby out [with] the bathwater, and lose the many benefits of considering ESG factors in corporate and investment decisions.”

Alex Edmans actually recommends that the term “ESG” is retired and replaced with “Rational Sustainability”. As he says, “this article has proposed “Rational Sustainability” as an alternative to ESG – a term and practice that started off with much promise and good intentions, but has not achieved this promise due to true believers implementing it naively, ardent adversaries opposing it blindly, and opportunists exploiting it for self-interest.”

Does ESG investing generate alpha?

Whether “ESG” is going to be retired or not, trillions of dollars all over the world are tied up in various ESG strategies, and that legitimises the question: does it add alpha, or is it just a fad? Two comments before I answer that question. First and foremost, the ESG ratings system is far from consistent. A company that may be rated non-compliant by one ratings provider, may score well with another provider. Let me give you one example, provided by Research Affiliates: “[We compared] two companies, Wells Fargo and Facebook, and showed that one ESG ratings provider rates Wells Fargo positively and Facebook negatively, while a second ratings provider ranked them the opposite way. In addition, we demonstrated that a portfolio construction process using the same methodology, but different ESG ratings providers, can yield different results.”

I suppose one could argue that ESG scores do not have to be consistent from ratings provider to ratings provider. After all, ESG scores are not objective. Having said that, it makes it a great deal more complex for investors to use the output.

Secondly, in order to get statistically robust results, decades of data shall be required, but that data does not yet exist – the concept is still too young. You can see the consequence of that in the t-value statistics in Exhibits 1a-1b below. The t-values in the two tables are, in most cases, way too low to be statistically significant.

With those two caveats, let me answer the question from earlier and, to do that, I have chosen to share Research Affiliates’ work on the topic with you. As you can see above, overall, ESG does not appear to generate any alpha. In fact, ESG strategies under-performed broad market strategies in the 2010s. It is also noteworthy that the difference between the US and Europe is so large. It is tempting to conclude that ESG investing works better in Europe than in the US, but the low t-values make such a conclusion unreliable.

Of the three pillars, the “E” was the only one to generate a meaningful amount of alpha in the 2010s. Admittedly, the “S” seemingly generated some alpha too (in the US but not in Europe); however, the t-value is far too low to take that number seriously.

The diehards won’t care. They will argue that, if we don’t change corporate behaviour, one day, there won’t be a market to invest in. The opportunists will care, though, and I don’t think it is any coincidence that the “E” appears to have generated plenty of alpha in Europe, whereas the “S” and the “G” have not. Opportunists – or tourists, as I call them – are by definition opportunistic. When they see climate horror stories plastered all over the frontpages, they act.

Now, if ESG investing is losing momentum, some tourists will arguably leave, and that should reduce the alpha opportunity. It is still too early to say precisely how big this issue is, but it should be closely monitored. Another drama worth tuning into over the next several months is the November elections on Capitol Hill. One would assume that Biden would be better for the “E” than Trump, but take a look at Exhibit 2 below. As you can see, markets sometimes behave differently from what one would expect. (The full text provided by Reuters to support Exhibit 2 can be found here.)

Obama struggled to execute his green agenda, and he struggled because the Dems didn’t hold the required majority in Congress. It is worth reminding yourself that the same could quite easily happen in the next term, whether the White House goes to Biden or Trump. The sitting president is always quite lame without the necessary support in Congress.

Final few words

Just one more point to wrap it up for this month. In the links I provide in the afterword below, you’ll find some very contrasting views, which is probably a function of the inconsistent approach amongst ratings providers that I referred to earlier. I have chosen to go with Research Affiliates, as I respect Rob Arnott and his team for the high-quality work they do, but I could easily have reached another conclusion, had I gone with somebody else.

Niels C. Jensen

2 April 2024

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Afterword

I am sure some of our readers find this topic terribly unexciting, but I am also aware of quite a few who will read this even if dinner has just been served. In case you want to read more about this topic, here are some interesting links:

Can ESG add alpha?

Dissecting the explanatory power of ESG features...

ESG factors and equity returns - a review of recent industry research

ESG, fundamentals and stock returns

ESG integration

ESG role in equity performance...

How is ESG affecting stock returns?

Is ESG a factor?

Positive ESG performance improves returns globally, research shows

Rational sustainability

Responsible investing - the ESG-efficient frontier