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Faculty Op-Ed: Ignoring ESG Risk Factors Could be Hazardous to Your Wealth

Faculty | Aug 08, 2023 |

ESG investing has reached a political flashpoint in the U.S. Florida has barred state pension fund managers from considering environmental, social, and governance (ESG) factors when choosing investments and prohibited state and local governments from weighing ESG factors when selecting investments. A coalition of 18 Republican governors has agreed to follow Florida’s lead and bar consideration of ESG factors.

This extreme prescription notwithstanding, portfolio managers would be wise to take risk-related ESG factors into account when applying traditional portfolio risk-return metrics. ESG risk is an important portfolio risk. Ignoring the information ESG factors convey about this risk leaves a portfolio exposed to poorer returns relative to the amount of material ESG risk it bears.

ESG investing is complicated because it involves what economists call externalities. These include negative externalities like emitting more greenhouse gases (GHG) as well as positive externalities like cutting GHG emissions that affect parties outside the business. Belching GHG into the Earth’s atmosphere can benefit company shareholders at the expense of external parties who bear the cost of the incremental impact on climate change. Likewise, cutting GHG emissions is expensive for shareholders, who bear the cost while external parties reap the benefits.

Nevertheless, positive externalities can benefit shareholders in two ways. They can burnish a company’s reputation. Strengthening a company’s image can produce long-term value. Second, lowering GHG emissions attenuates a firm’s climate change transition risk. The anti-ESG movement focuses too much on immediate monetary costs while underestimating shareholder-value creation.

Research by one of the co-authors of this article [link] demonstrates that investors integrate ESG factors into investment decision-making for these two distinct reasons. One is non-pecuniary. Some investors believe sustainable investments will make the world better off. They are willing to sacrifice some of their pecuniary return for the non-pecuniary benefit. The other motive is pecuniary. Risk averse investors seek ESG-risk-mitigating investments. They, too, are willing to sacrifice some of their investment return to lower investment risk.

ESG investing’s critics, like the Republican coalition, ignore the pecuniary ESG motive. That is why their investment policy prescription is ill-advised. A sustainable investment that reduces exposure to macro-level ESG risk will likely have an expected return that is less than the expected return of a comparable non-ESG investment due to the risk-return trade-off that characterizes investing. But the reduction in non-diversifiable ESG risk means that the expected risk-adjusted return could nevertheless match or exceed the non-ESG alternative’s expected risk-adjusted return.

Risk-adjusted returns are what really matter to risk-averse investors. [link] Portfolio choice depends on carefully balancing portfolio risk and expected return. Higher returns and lower risk both make a risk-averse investor better off. Unfortunately, ESG investing’s critics overlook the information that ESG risk factors can convey: the exposure to systematic ESG risk. Ignoring a significant component of portfolio risk will penalize a portfolio’s rate of return when the risk materializes.

Indeed, research finds ESG factors do convey useful information. [link] We agree that an investor should not blindly base investment decisions on a stock’s ESG rating. But certain ESG rating metrics are informative of ESG risk. You would never know that from the debate over ESG investing. Critics of ESG investing treat all ESG strategies as homogeneous ignoring the risk reduction.

One of the main reasons the ESG debate has generated more heat than light is that there is confusion regarding the returns to ESG investing. First, there is no consensus concerning what ESG means; the term ‘ESG’ lacks a precise definition. Consequently, attempts to determine whether the returns to ESG investing are higher or lower depend on how a researcher selects the pool of ‘ESG’ funds to test. Unfortunately, greenwashing creates further confusion because a fund’s name can lead to misclassification.

Second, realized returns differ from expected returns. Past researchers have calculated realized returns when comparing ESG and non-ESG investments. It is important to compare expected returns because large amounts of investor funds persistently flowed into ‘ESG’ mutual funds between 2012 and 2020. This created a flow-induced upward bias in ESG realized returns. [link] Consequently, realized ESG returns tended to exceed expected returns. Moreover, ESG realized returns often exceeded non-ESG realized returns even though the expected returns were lower. [link] Academic studies comparing returns were inclusive. Some found that ESG investing produced lower returns (relying on periods with relatively modest ESG fund inflows while others concluded that ESG returns were higher (during periods with large ESG fund inflows).

Third, expected returns should be adjusted for investment risk. Comparing two investments that are identical except one reduces ESG risk, the ESG investment will have a lower expected return due to the risk-return trade-off. But its risk-adjusted return could be equal or greater. Dismissing the lower-expected-return ESG investment is misguided when its risk reduction leads to a superior risk-adjusted return. This does not mean every ESG investment necessarily belongs in the portfolio. The value of risk reduction needs to be weighed against the reduction in expected return. But it would be very unwise to ignore ESG factors because a portfolio manager will overlook attractive investment opportunities.

ESG ratings can proxy for the two ESG investing motives. [link] For example, MSCI’s Intangible Value Assessment (IVA) firm-level ESG rating proxies well for ESG investing’s non-pecuniary benefits. RepRisk’s Reputational Risk Index (RRI) proxies well for the downside ESG-risk exposures investors internalize as shareholders. IVA focuses on evaluating the effectiveness of a firm’s ESG strategies and its historical management of previously encountered ESG events. RRI focuses on gauging a firm’s exposure to future ESG-related pecuniary risk events. IVA and RRI distinguish well enough between the non-pecuniary and pecuniary ESG investing motives. Thus, ESG factors can easily be integrated into portfolio selection, and the ESG-related pecuniary benefit of risk reduction can be distinguished from non-pecuniary ESG investing strategies by selecting appropriate ESG rating metrics.

Integrating risk-related ESG factors into portfolio selection will achieve what ESG’s most strident critics are ultimately after, namely, better risk-adjusted investment returns.

Written by:

John Finnerty, Ph.D. is a professor of finance and business economics at the Fordham University Gabelli School of Business. He is the managing principal of Finnerty Economic Consulting. Before assuming this role, he served as managing principal of Analysis Group, partner at PricewaterhouseCoopers, director at Houlihan Lokey Howard & Zukin, and general partner at McFarland Dewey & Co. He is a professor of finance and business economics at the Fordham University Gabelli School of Business.

Paul Yoo, Ph.D. is a recent graduate of the Kenan-Flagler Business School at the University of North Carolina – Chapel Hill. He is an assistant professor of finance at American University’s Kogod School of Business. Yoo worked as a research assistant at the Board of Governors of the Federal Reserve System. He graduated from Columbia University with a B.A. in Financial Economics and concentrations in mathematics and business management. His research interests cover sustainable finance, fintech and banking, and monetary economics.

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