Better ESG scores of listed companies do not necessarily lead to higher equity returns. Contrary to the claims of numerous asset managers, this link cannot be scientifically proven, according to researchers from Erasmus University and Boston University.
Asset managers often cite scientific studies that purport to establish a causal relationship between sustainability and stock returns. They argue that a higher ESG score increases the likelihood of positive returns for investors in the company’s shares.
“This is a farce,” states Luca Berchicci, Professor of Entrepreneurship at Erasmus University. He suggests that asset managers are potentially attracting billions of dollars towards profitable ESG strategies under false pretences.
Berchicci comments, “While I believe ESG investing is commendable, there exists no scientific causal link between superior ESG performance and higher equity returns. The financial argument is fundamentally unscientific.”
Incorrect data
Berchicci, alongside Andy King, Professor of Business Strategy at Boston University, replicated the study titled “Corporate Sustainability: First Evidence on Materiality” by Mozaffar Khan, former professor at the University of Minnesota, along with George Serafeim from Harvard and Aaron Yoon from Northwestern University. These researchers had claimed that companies with robust ESG ratings significantly outperformed those with lower ratings.
The article was cited hundreds of times, making it into the top 1 per cent of economic and business papers in 2015, according to Bloomberg, which utilises data from the academic research database Web of Science. It also became favoured amongst asset managers like BlackRock and Morgan Stanley, who profit from selling SRI strategies.
According to Berchicci and King’s study, “Corporate Sustainability: A Model Uncertainty Analysis of Materiality”, researchers in the US make questionable decisions in compiling their datasets, leading to specific, albeit unreliable, results.
Berchicci explains that the original researchers claimed to scientifically demonstrate that portfolios built using “materiality-weighted ESG measures” would outperform the market. “Our research, which subjected the American analysis to scrutiny across hundreds of datasets, suggests that such a portfolio would likely hold no advantage,” he remarked. “There’s even a risk of a negative outcome due to the higher average cost of sustainable strategies compared to their unsustainable alternatives.”
Berchicci notes that many studies asset managers cite to justify the financial benefits of ESG investing fall into the classic correlation-causation error. Companies that are larger, older, and more profitable may find it easier to improve their ESG scores. “It’s likely these characteristics, rather than higher ESG scores, that could lead to stock outperformance,” he explains.
Conflict of interest
Berchicci suspects that fund providers have a vested interest in citing academic papers that link ESG and returns because ESG strategies command higher fees. He observes that financial entities in the Netherlands are also engaging in this practice.
He personally liquidated his equity portfolio at ING after the bank announced that his investment strategy would undergo a sustainability transformation, unwilling to accept the increased fees ING would charge its clients for this green initiative.
His colleague, King, laments how ESG research has contributed to a proliferation of sustainability funds, leading to a somewhat uncritical belief that wealth can simultaneously generate profit and save the planet.
Lack of transparency
Berchicci highlights a lack of transparency in the scientific literature regarding the relationship between ESG and stock returns, particularly concerning methodology and conflicts of interest. Many US researchers have financial sector affiliations, serving on boards or as consultants. This includes the three authors of the study Berchicci and King critiqued.
George Serafeim of Harvard holds paid advisory roles at Apax Global Impact, State Street Associates, Neuberger Berman, and Summa Equity, among others. Aaron Yoon serves as an advisor at management consultancy Bain & Co, and Mozaffar Khan is a portfolio manager and head of sustainability research at Causeway Capital Management.