Socially responsible investing (SRI) is a well-worn term that grew in prominence during the 1980s and 1990s, but its roots trace back two millennia, shaped by civil-rights-era thinkers, faith-based organizations, and women (Townsend, 2020). The modern SRI process stands on three pillars: (a) values-based avoidance screens; (b) proactive sustainability-focused analytics, i.e., the environmental, social, and governance (ESG) investing; and (c) corporate engagement and impact investing. As for the second pillar, ESG, the assets under management (AUM) in ESG mutual funds and exchange-traded funds (ETFs) grew from US$453 billion in 2013 to US$760 billion in 2018, excluding the private funds investing directly in sustainable infrastructure and other assets (BlackRock, 2020).
Townsend (2020) focused on the origins and continued evolution of the first two pillars, the traditional North American model for SRI, and ESG, which first took hold in Europe. Townsend (2020) found SRI and ESG had roots in not only faith-based investing, but also in the civil rights, antiwar, and environmental movements of the 1960s and 1970s. Townsend also found the investment risks posed by climate change and poor corporate governance provided a huge catalyst in the growth of ESG investing. By contrast, Elsenhuber and Skenderasi (2020) provided an overview of ESG investing from the perspective of public investors. To evaluate the role of public investors in sustainable investing, Elsenhuber and Skenderasi noted the Bank for International Settlements conducted an informal survey among many central banks, international organizations, and asset managers between April and May in 2018.
Pástor et al. (in press) suggested the ESG factor and the market portfolio priced assets in a two-factor model. The ESG investment industry is largest when investors’ ESG preferences differ most (Pástor et al., in press). The findings of Townsend (2020) suggested ESG data were much more widely available than those back 10 years ago, making ESG investing increasingly viable.
ESG Ratings and Methodologies
ESG investing is becoming mainstream, and the COVID-19 pandemic has amplified the momentum (Abhayawansa & Tyagi, 2021). The interest in ESG investing creates greater demand for ESG data, ratings, and rankings, spawning a proliferation of agencies offering these products (Abhayawansa & Tyagi, 2021). In fact, different ESG ratings and rankings produce significantly different assessments of the ESG performance of companies (Abhayawansa & Tyagi, 2021).
Dimson et al. (2020) examined the extent of, and reasons for, disagreement among the leading suppliers of ESG ratings, and found the weightings given to each pillar of an ESG rating also varied across agencies. Dimson et al. also reviewed the investment performance of portfolios and of indexes screened for their ESG credentials. The findings of Dimson et al. (2020) indicated ESG ratings, used in isolation, were unlikely to make a material contribution to portfolio returns. Surprisingly, Dimson et al. provided evidence that ESG indexes did not outperform the parent index from which they were derived over the longest available period. While the findings of Dimson et al. also revealed FTSE4GOOD and MSCI-ESG, the two indexes that most closely represented what ESG investors did, showed no evidence of underperformance.
Unlike Dimson et al. (2020), Abhayawansa and Tyagi (2021) examined the causes of differences in the ratings and rankings generated by different agencies. The results of Abhayawansa and Tyagi (2021) indicated the divergences among raters could be attributed to differences in the definitions of ESG constructs, which was a theorization problem, and methodological differences, a commensurability problem. The results also revealed while users of ESG ratings were advised to study the definitions and methodologies before their use. A lack of transparency about the data sources, weightings, and methodologies could also make it difficult to ensure that the true ESG performance of companies was accounted for when making security selection and portfolio investment decisions (Abhayawansa & Tyagi, 2021).
Dimson et al. (2020) explained why different raters’ appraisals diverged, and whether ESG was associated with subsequent fund or index outperformance. Dimson et al. argued data were essential for making investment decisions, and most institutions relied wholly or partly on external providers of ESG data; however, minimal correlation existed between ESG ratings from alternative agencies. Anson et al. (2020) identified a sustainable beta factor that was successful in screening both companies and asset managers as green or nongreen, which was an important step in building a factor model for sustainable investing. Elsenhuber and Skenderasi (2020) indicated central banks had introduced ESG factors mainly for their pension fund investments, with the aim of further integrating sustainable investing into their own funds and in foreign exchange reserves portfolios. This is because the strategic asset allocation of the latter tends to be less diverse, and it focuses on the asset classes that does not have a conventional ESG approach.
Investment Performance of ESG-Rated Funds
ESG investing remains a topic of keen debate, largely from the investigation of its performance over different periods (Anson et al., 2020). A natural question concerns how ESG attributes affect expected return and risk (Madhavan & Sobczyk, 2020). Unfortunately, the databases that accumulate sustainable metrics are both inconsistent and incomplete, leading to a large dispersion of results and conclusions (Anson et al., 2020). Anson et al. (2020) devised an empirical test of the value of sustainable investing that did not depend upon the choice of sustainable database or metrics used. The results of Anson et al. (2020) revealed a negative alpha associated with the sustainable funds, compared to a portfolio not constrained by a sustainable mandate.
Inconsistent with Anson et al.’s (2020) results, Giese et al. (2019) examined three transmission channels within a standard discount cash flow model: (a) the cash-flow channel; (b) the idiosyncratic risk channel; and (c) the valuation channel. Giese et al. provided a link between ESG information and the valuation and performance of companies. Specifically, Giese et al. tested each of these transmission channels using MSCI ESG Ratings data and financial variables, and the results showed the ESG information of companies was transmitted to their valuation and performance, both through their systematic risk profile and their idiosyncratic risk profile.
Most recently, Pástor et al. (in press) modeled investing that considered ESG criteria. The results of Pástor et al. (in press) revealed in equilibrium, green assets had low expected returns because investors enjoyed holding them and because green assets hedged climate risk. Pástor et al. found green assets nevertheless outperformed when positive shocks hit the ESG factor, which captured the shifts in customers’ tastes for green products and investors’ tastes for green holdings.
Apart from ESG equity investments, interest in sustainable investing in fixed income has also grown tremendously (Madhavan & Sobczyk, 2020). Theoretically speaking, bond ratings for a particular issuer are broadly similar regardless of the rating agency; however, this is not the case for ESG ratings (Dimson et al., 2020). Companies with a high score from one rater often receive a middling or low score from another rater (Dimson et al., 2020).
Using quarterly holdings data, Madhavan and Sobczyk (2020) conducted a study for a broad sample of US fixed income active mutual funds to determine their performance attribution. Specifically, Madhavan and Sobczyk aimed to attribute active returns to (a) the returns to static factor exposures; (b) time-varying factor exposures; and (c) security selection. Madhavan and Sobczyk found funds with strong ESG attributes derived a significant fraction of their alpha from static factor exposures, which reflected a tilt toward higher-quality bonds that were less volatile.
The evidence of Madhavan and Sobczyk (2020) indicated a strong negative relation between a fund’s total return and its holdings-based ESG score. This holdings-based analysis of active fixed-income mutual funds provides deep insight into the relation between ESG attributes and investment performance. Madhavan and Sobczyk (2020) suggested funds whose holdings could be mapped to ESG attributes derived a significant fraction of their alpha from static factor exposures, reflecting the composition of their bond portfolios.
Summary and Conclusion
The survey results of the Bank for International Settlements indicated public investors were increasingly being pressed to play a role in sustainable investing, but they faced various challenges in this process (Elsenhuber & Skenderasi, 2020). Among these challenges, Elsenhuber and Skenderasi (2020) found the most critical ones were the lack of a commonly adopted ESG taxonomy, and the limitations on the application of various ESG approaches in some of the portfolios they managed. A key ingredient in growing ESG investments would be achieving a common understanding across asset owners, asset managers, other market participants, and regulators of what was expected from financial products that offered exposure to sustainable investment themes (BlackRock, 2020). BlackRock (2020) argued this would require a strong system of classification that could enable asset owners to differentiate products and provided clear, transparent data regarding product attributes.
The results of Giese et al. (2019) suggested that changes in the ESG characteristics of a company might be a useful financial indicator. Giese et al. (2019) argued ESG ratings might be suitable for integration into policy benchmarks and financial analyses. Abhayawansa and Tyagi (2021) argued instead of attempting to compare and contrast ratings and rankings of different agencies, investors should determine the ESG constructs that were material to their own investment strategies, and then matched them with an ESG rating or ranking product that closely resembled those constructs. Anson et al. (2020) suggested a sustainable factor could be identified and applied to both companies and fund managers. Anson et al. (2020) argued sustainable funds had consistent factor and sector tilts that must be accounted for as part of the portfolio construction process.
As for investment performance, the databases that accumulate sustainable metrics may be limited and present inconsistent and incomplete data, leading to a large dispersion of results and conclusions (Anson et al., 2020). On the other hand, Madhavan and Sobczyk (2020) provided evidence the composition of ESG scores mattered, with environmental score most closely related to fund volatility. Regardless of the debate on investment performance, sustainable investing nonetheless produces positive social impact by making firms greener and by shifting real investment toward green firms (Pástor et al., in press).
Keywords: ESG investing, fixed-income portfolio management, portfolio theory, portfolio construction, style investing, portfolio management, multi-asset allocation, factor-based models, security analysis and valuation, risk management, equity portfolio management, foundations and endowments, performance measurement, wealth management, sustainable investing, socially responsible investing, ESG, social impact
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