In response to my post about Don Boudreaux’s and my recent op/ed in the Wall Street Journal in which we argued that ESG would get in the way of maximizing shareholder value, frequent commenter (and friend) David Seltzer pointed out that the “annualized return was 0.02% higher for the S&P 500 ESG Index than the S&P 500.” It seemed to him to follow that ESG investing does not hurt shareholder value.
We had a phone call recently in which I explained why it does hurt shareholder value and why the evidence on shareholder returns is not evidence.
Here’s my explanation. Let’s say a bunch of hypothetical firms decide, without warning, that they will go ESG. If I’m right that it creates uncertainty about what steps the company will follow, then the market value of those firms should fall relative to the market value of firms that haven’t made such an announcement but instead have announced that they won’t do ESG.
If that happens, that won’t contradict the findings that David reports above. The reason is, essentially, arbitrage. Once the firms’ values have fallen relative to the values of the other firms, it would be a disequilibrium if their values didn’t rise just as much as those of the other firms from this point on. So someone examining the values of ESG firms will not find a lower rate of return. The rate of return, risk adjusted, will be the same. But the announcement of ESG will have caused a one-time reduction of the value. (Of course, if they get even more “ESGer” in the future than the participants in the market expected at first, the market values of those firms should rise more slowly than the market values of the other firms.)
This, by the way, is why financial economists do event studies. They want to find an event that is a surprise to the market and that is expected to affect the market value of specific firms. So they look at cumulative average residuals of that subset of firms from a few days before the event to a few days after.
I’m going from memory here about what I learned from dozens of financial economics presentations at the University of Rochester’s Graduate School of Management in the mid to late 1970s when I was an assistant professor, and also what I used to complete my Ph.D. dissertation in 1976. If the literature has changed substantially, I’m open to hearing about it. But here’s what ChatGPT told me:
The event window is the period of time over which the effects of the event are expected to be reflected in the stock prices of the affected companies. The event window typically starts a few days before the event and ends a few days after the event.
READER COMMENTS
Mark Barbieri
Apr 24 2023 at 9:09am
I have a more simplistic view. If ESG helped shareholder value, companies would do it without being asked. The only reason we need campaigns to get companies to behave in a certain way is to convince them to do something other than maximizing shareholder value.
John Hall
Apr 24 2023 at 9:18am
Mr. Seltzer doesn’t specify a time period for his analysis. I don’t have access to the S&P 500 ESG index right now, but I did a paired T-test between the MSCI USA total return index and the MSCI USA ESG Leaders total return index from 9/30/2010 (when my ESG data starts) to 3/31/2023 using monthly arithmetic returns. I did not find a statistically significant difference in returns over this period.
This is a situation where the two indices have a 99.2% correlation over this period. Where I’m going with this is that if you take a small active bet vs. some index, then it may be difficult to even determine that there is a statistically significant difference ex post, even if there might be good theoretical reasons why one should underperform.
A better way to measure the value of ESG would be by utilizing standard long/short portfolios that are commonly used in academic finance. So for instance, you create some ESG score and go plus the ones with the 10% best and short the 10% worst (or some variation of this) and then track the performance.
Dylan
Apr 24 2023 at 1:59pm
I’m curious on your numbers. When I looked at the numbers posted on the S&P 500 ESG fact sheet (USD), it looked like the ESG index outperformed the S&P 500 by ~1.5% on an annualized basis for the 3, 5, and 10 year periods, and about 0.3% for 1 year. What am I missing?
Mark Neuman
Apr 25 2023 at 11:19am
ESGU/ESGV….Blackrock’s and Vanguard’s ESG flagship fund.
Strip out the big tech (AMZN, AAPL, GOOGL, MSFT, NFLX, TSLA, NVDA) and you’ll see that ESG returns are conflated with big cap tech.
And the reality is, AMZN (biggest carbon footprint outside of energy, Bezos no friend to workers) and AAPL (helps CCP w surveillance, uses FoxConn sweatshop, “net zero” canard of buying right to pollute) are not ESG names at all yet appear as top 3 names in like 75% of ESG funds. GOOGL and “net zero” and biased search engines not much better.
Every new ESG fund piles into the same names. SPY, QQQ, ESGU, ESGV top names all identical. Love the, “Net zero pathways Paris-aligned,” greewash word salad all buying same names with faux ESG stamps on them.
Cliff Asness talked of ESG capital constraints “ancillary consequence is lower returns” and that ex-ante impact is immeasurable and ex-post is mostly all luck. Read his paper, “Virtue is its own reward: One man’s floor is another man’s ceiling,” from 5/2017.
Then read recent ESG paper from Yale, NYU, UPenn, Stanford: https://shorturl.at/gisA6
Correlation between big ESG investment and climate change scare (virtue or hedging) is huge. As is, lower returns from those investments accepted by most of the investors.
Finally, NYU’s Aswath Damodaran discussed ESG skepticism as “Saying good vs. doing good,” in a blogpost in 2020. All these companies game the DDQs to “qualify” and get the ESG stamp. See how that worked for FTX and SVB and made investors trust ESG stamps and stop doing due diligence.
Truth in ESG. Live an ESG life. Don’t fall for the stories sold as “ESG, everyone wins, it’s costless, saving the world.” There’s no free lunch. ESG imposes capital constraints resulting in misallocation of funds and malinvestment.
Mark Neuman CFA, founder/CIO of Constrained Capital.
Ray
Apr 24 2023 at 9:50am
While I’m not sure recent ESG results bear up to your friend’s claims, if you look at how ESG is implemented in companies, it’s really just a marketing strategy. Everyone is just working to have that “ESG” badge on their website and, much like security compliance frameworks, behind the scenes there is a lot of hand waving and gaming going on.
Shareholder value still dominates in the end. If shareholders are attracted by the “ESG” feel-good label, they’ll invest, but if companies stop making a profit relative to their competitors, ESG and the extra red tape causes it imposes will not remain important.
steve
Apr 24 2023 at 10:46am
While I can see a one time drop happening, if ESG is truly worse then I would actually expect it to continue doing worse compared with competitors. If after instituting ESG, companies continue to perform just as well then the one time drop was not merited and the complaints about ESG are all unmerited. I am betting, in my stock choices, that ESG companies will not perform as well and within a given sector have been making it a point to avoid ESG.
Steve
David Henderson
Apr 24 2023 at 11:15am
Steve makes an error here or, if not an error, an implicit assumption about investors’ expectations. I would point it out but instead I’m going to wait and see if anyone else catches it.
vince
Apr 24 2023 at 11:41am
Does the potential flaw depend on the way continuing performance is measured? If measured as percentage return on market value, the one time drop should have equalized it with competitors.
David Henderson
Apr 24 2023 at 4:24pm
Basically, you’re on the right track.
Once the company has announced that it’s ESG, its share price adjusts downward. But then arbitrage among stocks means that it goes up about the same rate as non-ESG stocks, all else equals.
The one way steve’s point could be true is if the company’s performance as an ESG company is even worse than participants in the market predicted.
steve
Apr 24 2023 at 4:54pm
My assumption is that stock value is related to earnings, not always true I know, and that a company which uses ESG as an investment strategy will have worse earnings than companies which do not. So if company A and B are in the same sector and roughly the same size doing the same work (competitors) and both have about 10% returns I expect the company that does not go into ESG to maintain its returns, all else equal. I expect the other company to show increasingly worse returns since I doubt they can instantly implement so it will take a while to get there. I also suspect that there is some rate fo lower return where the ESG company can no longer expect a premium from people willing to accept lower returns for the sake of their beliefs.
Steve
Dylan
Apr 24 2023 at 5:16pm
Maybe I’m missing something here, but I’m not aware of companies announcing that they are ESG companies like some kind of binary choice. In my experience, companies might make a commitment to reporting on ESG metrics, which is often at the behest of their investor base. Inclusion in an ESG index is based on criteria developed by the index maker and usually dependent on third party metrics, not something the company gets to decide and put an “ESG Badge” on their website as Raj suggests in the post above.
And, at least for the ESG 500 index, they have created a back-tested portfolio for those companies before the index was even constructed and going back 10 years. So, if there was a sudden downward pressure on the stock based on an “ESG announcement” you’d expect to see that in the data, right? Instead we see out-performance vs. the benchmark S&P500 for every period from as short as one month all the way back to 2013.
For the record, my hypothesis is that the ESG outperformance is due to mostly excluding heavy industry companies that are likely a bad investment for reasons other than their lack of sustainability. There’s a reason that VCs have invested so heavily in SaaS businesses and much less in hardware startups. But, I’m probably wrong about that. It sounds good and believable (at least to me!) when I say it, but if it is true I should be able to test it. I’d expect the same thing for the “ESG is bad for a company’s share value” hypothesis.
(This is all based on the fact sheet I linked to earlier, I’d assume that David Seltzer has access to Bloomberg and more ways of slicing the performance data than I do, so maybe I’m missing a subtlety that makes the performance data more equal than they appear to be, because a 5 year annualized net return of 12.1% ESG vs 10.6% for the benchmark is a pretty big difference)
David Seltzer
Apr 24 2023 at 8:01pm
Reply to Dylan. I referenced TEBI article by Ben Leale-Green, posted October 27,2019.
“I’m missing a subtlety that makes the performance data more equal than they appear to be, because a 5 year annualized net return of 12.1% ESG vs 10.6% for the benchmark is a pretty big difference)”
I suspect it depends on the fund you are referencing. For the SPY ESG fund, I calculated the average compounded return to be 10.62% compared to 10.38% for the S&P 500 for the same 5y period. The betas were nearly identical. Sharpe and Treynor ratios are nearly the same. I suspect the difference of 12.1% and 10.6% can be explained by a higher beta for the ESG, estimated 1.07, compared to the benchmark of 1. The second consideration that might explain the difference in returns; ESG tax credits for the largest industries producing greenhouse gases.
Dylan
Apr 25 2023 at 8:43am
Thanks for the response @David. I’m curious if the dates explain it, as of October 2019, there would only be ~10 months of data for the SPXESUP (not counting back dated info). Hopefully this is a direct link to the fact sheet on the index current through March 2023. The beta could explain the difference, but I found it interesting that the ESG index has outperformed even during the market weakness of the last year. If it was just beta, you would have expected it to do worse in a bear market.
nobody.really
Apr 24 2023 at 11:13am
Would we draw the same conclusion about firms that had no specific policy and abruptly announce that they would NOT adopt an ESG policy? How about firms that had an ESG policy and abruptly announce that they would abandon their ESG policy?
Today, should I invest in the stock of ESG firms or non-ESG firms? It sounds as if the two categories would be comparable—except that the ESG firm would always have the option of announcing that they’re abandoning their ESG policies, thereby triggering a rise (?) in stock price. The non-ESG firm would not have that option.
This reminds me of Mark Twain’s Following the Equator: A Journey Around the World (1897):
vince
Apr 24 2023 at 11:56am
This is a tricky subject. If maximizing SH value means maximizing the stock price, it involves predicting stock movements. I’m not sure anyone can consistently do that without insider trading. Warren Buffett? Many corporations try to build goodwill value. If ESG does that, the stock price rises. For counterexamples, look at SVB and Anheuser Busch.
Jon Murphy
Apr 25 2023 at 7:53am
I don’t understand your logic here. How does insider trading fit in? There’s no trading going on.
Jose Pablo
Apr 24 2023 at 5:59pm
Maybe there is a much easier explanation for the outperforming of the ESG index.
Basically, the index composition is revised following criteria that include a lot of leeway for arbitrariness …
… for instance, what if in a period in which the value of oil companies is going up and the value of technological companies is going down, you decide that Exxon qualified to make to the top 10 of ESG companies while Tesla is kicked out the list?
https://www.cnbc.com/2022/05/18/why-tesla-was-kicked-out-of-the-sp-500s-esg-index.html#:~:text=In%20a%20blog%20post%20Wednesday,%2C%20California%2C%20affected%20the%20score.
You have to be very clumsy or very honest (or both) to have all this leeway to make and index and not “manufacturing” an index that outperforms the S&P500
Dylan
Apr 25 2023 at 8:45am
What’s the incentive though? S&P is responsible for constructing the benchmark too, is there a reason that they would want one index to outperform the other?
Mark Neuman
Apr 25 2023 at 2:48pm
Jose Pablo,
TSLA went lower, XOM went higher in ESG for the following reason:
TSLA did not change much of their behavior. Setting aside horrible “G” in Musk’s sake viz a viz the board and the “E” in the manufacturing of the vehicles, the car fires that require 20k gallons of water to put them out, and the tearing apart of the earth to mine for metals, etc.
XOM went ahead and sold off parcels of their public assets to private equity interests under much less scrutiny. So when XOM fills out the due diligence questionnaire’s from the ESG masters, they can say that they divested of O&G properties. So in the DDQ mind they are better as they “gamed the system” and appear like ESG do-gooders
In actuality, what happened? Some much less scrupulous private equity firm took over the O&G assets. This number is in the trillions over the past few years, btw. Did the O&G equation change at all? No. All that happened is XOM’s visibility improved in order to win favor in the ESG world and see a better ESG rating. The Environment is no better off because some other outfit is producing the O&G and are not subjected to ESG scrutiny.
So the entire rating system is a complete fabrication. For the record, Tesla is not a really great ESG company. It just isn’t. Is it better or worse then XOM? Well, I’d bet you XOM is leading us to future energy, alternatives, and attempts at a cleaner product. Is it a better ESG steward than TSLA? Debatable. Governance and worker satisfaction is probably higher at XOM, my guess.
But the end goal is not ESG for these companies. It’s getting inflows and better funding deals to carry on with their business. All they need to do is jump through the bureaucratic hurdles and “Say good” versus actually, “Doing good.”
David Henderson
Apr 24 2023 at 6:01pm
Reply to steve above:
steve writes:
That’s my assumption too.
steve writes:
I agree.
steve writes:
That’s reasonable. And if other investors think the way steve does, the price will fall at the start to reflect that. Then normal returns from then on.
Dylan
Apr 25 2023 at 8:49am
This is a good hypothesis. Another is that investors might expect earnings to improve longer term with ESG strategies by, for instance, being ahead of the curve if a carbon tax gets enacted. Either way, we should be able to see it somewhere in the data.
Knut P. Heen
Apr 25 2023 at 6:10am
This is a complicated problem.
First question: Does ESG investments increase cash flows sufficiently to pay for the investments in ESG?
Second question: Does ESG reduce the cost of capital?
These are both empirical questions which have to be resolved.
If ESG investments are positive NPV investments, there is no difference between investing in ESG or investing in anything else.
If ESG affects the cost of capital, it is meaningless to compare the returns on a ESG-portfolio with the return on a non-ESG-portfolio. The difference only tells you how much the market is willing to give up to put their money in the ESG-portfolio. It says nothing about whether it is a good investment or not.
The rational approach is to put your money in good ESG investments and not in bad ESG investments. If you have nightmares about climate change, go ahead and put some of your money in bad ESG-investments too. May be you will dream about angels instead.
Knut P. Heen
Apr 25 2023 at 6:39am
There are not big changes in the event study method that I am aware of (some econometric improvements). The problem in the present case is that the interest in ESG-investments has increased slowly over a very long time window without many specific events such that it is difficult to find good events and event-windows. If corporations suddenly were declaring “we are an ESG corporation now”, you could easily do such a study.
Dylan
Apr 25 2023 at 9:05am
Exactly this. The whole point of this post seems to come from the mistaken idea that corporations are declaring themselves “ESG” as if that means anything. Companies have been giving marketing dollars to show their commitment to what we might call “ESG values” for far longer than the term ESG has been around, and while that might have increased in recent years, you’re right that it is hard to find an event window to use in a study. Although, I’d say that inclusion in an ESG index could be one opportunity.
Knut P. Heen
Apr 25 2023 at 3:10pm
Two points.
Point one, I think you may be right about virtue signaling (nothing real going on), but an event study should then show no price reaction on the ESG announcement.
Point two, I thought about index inclusion too when I wrote earlier today. Skipped it to be somewhat short. The problem with this approach is that index inclusions themselves (even S&P500) lead to price reactions because index funds are forced to buy mechanically. There is a fairly long literature on the effect of index-inclusions. It gives a positive price reaction. Negative if your excluded. It would be difficult to disentangle the pure ESG-effect from the ESG-index-inclusion-effect.
Dylan
Apr 25 2023 at 3:37pm
On your first point, I want to again push back on the idea that there is an ‘ESG announcement.” The only thing I can think of that would possibly count as an ESG announcement is that a corporate was going to start adding an ESG reporting section to their annual report, but that’s not really ESG, it’s just adding transparency to that part of the business. The “doing ESG’ part is a bunch of (mostly) tiny actions that might have been done anyway (generally speaking, increasing efficiency will also tend to lower your carbon footprint), but you now get the added boost of being able to brag about your green credentials.
On the second point, you’re right that using index inclusion as an event window would be complicated. You could potentially take it a step backwards, as the index partially bases inclusion on the basis of 3rd party groups that build lists of the top performing companies from an ESG standpoint in each sector. That probably has problems that I’m overlooking as well.
steve
Apr 25 2023 at 12:00pm
IBD, among others, have ESG ratings.
https://www.investors.com/news/esg-companies-list-top-100-esg-stocks-2022/
Steve
Mark Neuman
Apr 25 2023 at 2:38pm
ESG ratings meaningless. First, Russia higher ESG rating than the EU. See Feb 2022. FTX higher ESG rating than XOM. See Fall 2022. SVB had “Medium” ESG risk rating despite no Chief Risk Officer for 8mos. Abject failure in “G” and yet “Medium” ESG risk. A 3-legged stool without one leg, nobody sitting in that. But an ESG stamp caused everyone to stop doing due diligence and pile in, trusting someone else’s work.
I debunked the entire rating agency system. Think of GFC and CDOs and the complicit rating agencies like Fitch, Moody’s, and S&P. This time around, same movie, different actors. All complicit with Wall St. MSCI cares about making ESG indices and getting paid about 1000x more than they actually care about ESG.
At conferences last year both Federated and Fidelity said, “We are developing our own ESG rating system on top of the existing one.” Gee, great. On a foundation of sand, those two behemoths forming their own meaningless rating system. There is no universal measure of “Goodness.” It’s personal. Larry Fink can’t decide for anyone else, what’s the best E, S, or G pursuit. He doesn’t know my preferences. There is no “ESG” panacea in some arbitrarily selected stock basket.
ESG just another Wall St. cottage industry supposedly benefitting many but in fact enriching just a few. The losers are investors, society, and the economy. Who paid for the SVB bailout? How many politicians got paid tributes from FTX?
Aswath Damodaran told me, “Two types of people pushing ESG now, feckless knaves or useful <fools>, there is no 3rd category.”
I’m with the Professor on this one.
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