‘Honey, I Shrunk the ESG Alpha’: New Research Questions Outperformance Data

Outperformance from environmental, social and governance (ESG) themed funds disappears when adjusting for risk, a new report has claimed.

A significant body of research has developed in the past few years indicating that investors do not need to sacrifice returns in order to invest in ESG-themed products or strategies.

However, smart beta group Scientific Beta argued in a paper that a lack of consideration of risk may have produced inaccurate results in some of this research.

The firm’s report – titled ’Honey, I Shrunk the ESG Alpha’: Risk-Adjusting ESG Portfolio Returns – argued that there was no solid evidence supporting claims that ESG strategies generate outperformance.

Scientific Beta found that, while headline figures from ESG strategies appeared attractive, with annualised returns of roughly 3% per year, none of the 12 strategies it studied offered “significant outperformance” when exposure to standard factors were taken into account.

According to the research, 75% of the outperformance was a result of “quality factors” it claimed were “mechanically constructed from balance sheet information”, rather than specific environmental or social factors.

The paper did not dispute that ESG strategies could offer substantial value to investors. Instead, it suggested that investors wanting added value through outperformance should adjust their vision.

Dr Noël Amenc, CEO of Scientific Beta, said: “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.”

In November last year, figures from Fidelity International’s ‘Putting Sustainability to the Test’ report showed that stocks at the top of the fund house’s ESG rating scale outperformed those with weaker ratings in every month from January to September, apart from April.

However, Scientific Beta’s research argued that this paper illustrates a good example of banks or institutional investors pointing to outperformance where there was none.

Dr Amenc warned: “Omitting necessary risk adjustments and selecting a recent period with upward attention shifts enables outperformance to be documented where in reality there is none.”