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For centuries, few words could get an investor’s blood-pumping more than above-average returns. But that may be changing.
ESG ratings can be thought of as a report card (by an independent evaluator) that summarizes a company’s resilience to environmental, social and governance risks. By identifying systemic risks like emissions, industry disruption, community relations, and worker health & safety, investors can make less risky which should be more profitable returns.
- Investors are focusing more than ever on sustainability. A high-ESG rating can get people more excited than an Apple launch party.
The theory is appealing: invest to earn better returns and make the world a better place. Win-win. Easy, right?
Maybe not. An article by high-profile NYU finance professor, Aswath Damodaroan, has recently cast some doubt on the effectiveness of ESG investing.
Does ESG make the world better?
Better or good is difficult to measure objectively.
- Individuals hold different values, so what’s good to one may be different to another.
- ESG ratings agencies often disagree on how individual companies should be ranked. Agencies are financially motivated to develop their own unique rating system so to differentiate themselves from others.
Issues investors care about in their portfolios
percentage by age group and issue
Courtesy of Aswath Damodaroan
Does ESG investing at least make you richer?
To date, there is little evidence to show a link between high-ESG ratings and increased profitability.
- Investing in companies with high-ESG ratings isn’t enough to outperform. It’s also critical to invest before the market reflects the higher ESG standards with a higher share price.
- Companies that are less sustainable (i.e. tobacco stocks) are viewed as riskier and so have a higher cost of capital, meaning investors demand higher returns to fund them. Ironically, investors then tend to earn higher returns from investing in sin stocks rather than in virtue stocks.
Don’t throw out ESG just yet: There are some studies showing that, in some situations, investing using ESG standards can be a predictor of future returns.
- Investors in low-ESG companies are more exposed to catastrophic failure and this risk of failure leads to long-term underperformance.
- Activist investors that invest in low-ESG companies and successfully push for improvement, do outperform the market.
Zoom out: A strategy to make the world a better place by investing in ESG funds might outsource difficult decisions, making investors less likely to improve the world in more direct and impactful ways.
Damodoran’s paper highlights important moral questions about whether society should turn social decision making over to ESG fund managers and ratings agencies, both of which are profit motivated.
+Read the full paper: The ESG Movement: The “Goodness” Gravy Train Rolls On!
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