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Was 2014 a Turning Point for ESG Investing?

Amundi, the French asset management firm that, less than a year ago, launched the world’s largest green bond and emerging markets-focused investment, has just posted a scholarly discussion, “How ESG Investing Has Impacted the Asset Pricing in the Equity Market.” 

The paper begins by saying that academic study of ESG firms thus far has exposed a U-curve. If one charts firms that rate very high by ESG metrics, they do very well in the equity markets. On the other hand, firms that rate quite poorly by those metrics also do very well in the equity markets. It is the in-between firms that do poorly. If, then, ESG score is the X axis and market performance is the Y axis, one gets a “U.”

Reports of this U incited a boom in so-called “sin stocks,” that is, in stocks that would be on the low side of the ESG axis quite intentionally. A famous 2009 paper on the subject was called simply “The Price of Sin.”

A New Hypothesis

One of the Amundi authors is an equity quantitative researcher for the firm, Leila Bennani. Bennani et al. maintain that much of the academic research has taken too long and historical a view of the data. The U charts are typically based on 25 years of data. The problem with that, though, is that the definition and use of metrics for ESG has progressed greatly in recent years, and it is possible that the earlier years from that quarter century span are throwing off the results with “noisy and non-robust results.”

These authors wanted to test the hypothesis that a change has taken place more recently, one that could get buried in the long view, and that the U curve, puzzling as it is in any case, may have become out of date.

Accordingly, they focused their own work especially on the period from 2010 to 2017, inclusive, using the metrics provided by Amundi’s ESG department.

They divided their data by strategy: active investing (stock picking); passive investing (using the broad indices) and factor investing (multi-factor portfolios).

As to the active portfolios, they found “no evidence of a consistent reward of ESG integration in stock prices between 2010 and 2013,” the first half of their chosen period. They confirmed the U-curve for the Eurozone during this period.

Europe, North America, Japan

But they also found that indicators turned positive for the years 2014-2017, the second half. In the Eurozone, buying the best-in-class stocks in each quarter and selling the worst-in-class stocks (where best and worst are defined in ESG terms) would have created an annualized excess return of 6.6% (In Europe outside of the Eurozone, ESG performance is very country-specific.) In North America the same strategy would have generated a consistently positive excess return through those years, although it would have been one just half the size: 3.3%.

But what if an investor implements an ESG approach from another direction? In particular, what if an investor used ESG benchmarking in connection with the MSCI World Index? This, the authors tell us, is the practice of “a large number of institutional investors.” The result again differs depending on the years whence one draws data. For the 2010-2013 period these portfolios have a negative excess return. For the 2014-2017 period their return is positive. Looking at the three initials of ESG separately: “In North America, the big winner is undoubtedly the environmental score [E] while governance [G] in Europe largely dominates the two other pillars.” The social pillar [S] “presents more neutral results” than either of the other two.

A factor portfolio approach shows that there is a lot of interaction between ESG and traditional risk factors. A multi-factor approach suggests that “ESG is significant in the Eurozone, but not in North America for the same period” (that is, since 2014). ESG also helps increase the diversification of multi-factor portfolios in the Eurozone. Here, the numbers from North America are ambivalent. One way of looking at these results is to say, as the Amundi paper does say in a footnote, that “ESG investing remains an alpha strategy in North America, whereas it has now become a beta strategy in the Eurozone.”

One oddity of the numbers is that in Japan, ESG seems to have done better in the period 2010-2013 than it did in the period 2014-2017. These authors offer no explanation for Japanese exceptionalism here.