A growing number of investors are incorporating environmental, social and governance factors into their investment strategies. Investor demand for ESG has resulted in a rapid proliferation of ESG-focused investment funds and products, as the Financial Times reported in February:
“ESG-focused equity funds have taken in nearly $70bn of assets just over the past year, according to EPFR, while traditional equity funds have suffered almost $200bn of outflows over the same period.”
The latest iteration of “socially responsible” investing, ESG has captured the imaginations of investors and allocators alike, yet many analysts and commentators have questioned whether ESG strategies can actually deliver market-beating returns. A Bank of America (BAC) research study has sought to dispel these concerns.
Bank of America is big on ESG
On Nov. 8, 2019, BofA Global Research published a comprehensive report on the efficacy of ESG strategies. Unlike most other analyses of ESG investing, which have relied principally on qualitative evidence, this report focused on identifying quantitative factors. According to lead author Savita Subramanian, Bank of America’s Head of Global ESG Research, there is “quantitative evidence that incorporating ESG into one's investment approach can enhance returns and reduce risk.”
According to the report, ESG investing offers two distinct advantages. First, it improves performance. The report found that the equities of companies that index higher on ESG factors outperforming those that do not consistently over the past five years.
Second, the report found that ESG investing can help investors avoid losses by reducing risk. According to BofA, “ESG metrics are the best measure for signaling future earnings risk – superior even to financial risk factors, like the level of a company’s leverage.”
If ESG strategies genuinely offer better returns at lower risk, as Subramanian and her colleagues have suggested, then why is there still a debate over their value? A closer look at each of the report’s claims may offer an answer.
Dubious performance advantage
BofA Global Research has claimed that companies committed to ESG outperform those that do not:
“U.S. companies with high (top quintile) ESG rankings in the S&P 500 index have outperformed their counterparts with lower (bottom quintile) ESG rankings by at least 3% every year for the past five years.”
A 3% annual performance spread certainly adds up, if it persists over time. A five-year time horizon is not insubstantial, but it is only half the length of what analysts conventionally consider the “long term.” This shorter time frame makes the claim of persistent outperformance somewhat dubious, especially in light of the data having been collected over a time period marked by a strong and stable bull market.
Moreover, the performance differential cited in the study is that between the top 20% and bottom 20% of companies ranked on ESG metrics. Given that governance is a key component of ESG, it is hardly surprising that the lowest scoring companies would lag the high-scorers. The differential is much reduced, and even virtually erased, when comparisons are made between the highest quintiles.
Analysis of performance claim
In my assessment, the conclusion that high performance on ESG metrics leads to superior company performance – and thus superior investment returns – is difficult to justify based on the relative dearth of comparative data, as well as the lack of substantial interquintile performance differentials beyond the most extreme cases.
However, there is a case to be made that ESG metrics can be used as a screening tool to identify high-risk companies. While there is little quantitative evidence to support making actionable distinctions between companies in the upper ESG quintiles, the comparative underperformance of the lowest-scoring companies tells us something valuable.
Thus, while it may not pay to invest in companies based on their particularly strong ESG metrics, it may be beneficial to weed out those that score especially low in terms of ESG. The potential utility of ESG as a negative screener becomes even clearer when one considers BofA’s other claimed advantage of ESG, that ESG-focused companies carry lower risk than their peers, as I will discuss in the next installment.
Disclosure: No positions.
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