In a new research paper, "Honey, I Shrunk the ESG Alpha": Risk-Adjusting ESG Portfolio Returns, Scientific Beta researchers examine equity strategies that exploit information in ESG ratings, following several papers that suggest that these strategies lead to outperformance. While many of the ESG strategies have positive returns, adjusting these returns for risk shrinks "alpha" (or excess risk-adjusted return) to zero. Sector biases and exposures to equity style factors capture the returns of ESG strategies. In addition, the analysis suggests that returns are inflated when investor attention to ESG rises.
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The findings do not question that ESG strategies can offer substantial value to investors. Instead, they suggest that investors who look for added value through outperformance are looking in the wrong place.
The research has important implications for investors. As a general matter, the analysis provides an example of how one can document outperformance where there is none: it is sufficient to omit necessary risk adjustments. Concerning ESG strategies, the findings question a widespread practice of using ESG as an alpha signal. They do not question the added value of such strategies on other dimensions, especially on the financial materialisation of extreme risk reduction, which still requires serious studies that are forthcoming.
Commenting on these findings, Dr Noël Amenc, CEO of Scientific Beta, said, "Claims of positive alpha in popular industry publications are not valid because the analysis underlying these claims is flawed. Omitting necessary risk adjustments and selecting a recent period with upward attention shifts enables outperformance to be documented where in reality there is none. Investors should ask how ESG strategies can help them to achieve objectives other than alpha, such as aligning investments with their values and norms, making a positive social impact, and reducing climate or litigation risk. These results also question the way in which ESG providers, and the investment industry more generally, promote ESG. By relying on biased research results, which as such have no value, the promoters of alpha in ESG investing are taking the great risk of disappointing investors on this supposed outperformance and diverting them in time from an investment theme that is important for sustainable economic development."
The Scientific Beta white paper on ESG alpha can be accessed through the link below:
"Honey, I Shrunk the ESG Alpha": Risk-Adjusting ESG Portfolio Returns, Scientific Beta Publication, April 2021
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