There are two reasons advisors and investors consider ESG investing, but thus far only one is grounded in reality, according to Envestnet’s Dana D’Auria.
D’Auria, co-CIO at Envestnet PMC, has noticed that advisors are increasingly pitching environmental, social responsibility and corporate governance-oriented (ESG) portfolios and investments on their potential to offer excess financial returns, or alpha, or market returns with less risk, a “smart” or “strategic” beta.
But thus far the evidence that ESG portfolios can offer alpha or a better form of beta remains unproven, making a more traditional moral rationale for ESG investing the safer argument from advisors, said D’Auria.
“There are thousands of papers on ESG, several meta-studies and even studies of the meta-studies trying to determine whether there may be some added financial benefit to ESG investing,” said D’Auria. “At the same time, we’ve seen several studies into the non-ESG stocks, the so-called sin stocks, that show they tend to outperform. So the idea that there’s a true alpha thesis for ESG is still in doubt, though there is some encouraging research emerging.”
Among such research are papers determining that environmentally sound companies have fewer regulatory and legal risks, that diversity on boards and in the C-suite can lead to better financial performance, and that socially responsible companies are less prone to costly boycotts and other reputational risks.
D’Auria also points out that the smart- and strategic-beta communities already have a proxy for good corporate governance in the quality factor – so it’s difficult to determine whether any form of good governance is delivering excess or better risk-adjusted returns beyond the benefits of investing in securities with quality factor characteristics.
“A lot of people think there won’t even be ESG investing in five to 10 years,” said D’Auria. “The theory is that we will reach equilibrium for the expectations of regulators and investors, these ESG externalities will be incorporated into securities prices by analysts, and any long-run beta benefits to ESG investing will dissipate. To have long-run beta, you have to have a reason to believe it will continue to be underpriced like small companies or value stocks, and I don’t know why that would be the case with ESG.”
But what about excess returns in the form of alpha from ESG investing? While D’Auria thinks there could be a short-term alpha thesis in ESG investing because of the rapid growth in interest in this kind of investing on the part of asset managers, advisors and end investors, that interest may end up outpacing the actual returns and cash flows of ESG-oriented companies. The result could be a downturn in the pricing for ESG securities, erasing any potential alpha benefits from investing in them.
The best reason for advisors to pivot towards ESG investing is not the promise of offering alpha or beta to clients, but because certain clients demand that their portfolios be brought in line with moral or political beliefs, said D’Auria.
ESG’s rise in prevalence has caught some advisors flat-footed, she said, as investors and asset managers respond to the potential for additional regulation, penalties for pollution and other corporate behaviors and shifting consumer interests.