In the companion piece to this article (ESG: Screaming Into The Void?), we argued that ESG investing is a logical projection of power from a certain class of investor looking to use the only tool they really have — money — to exert some influence on the state of the world. As we pointed out, the money is definitely there (some $40 trillion out of $120 trillion in global market cap currently can be flagged as “ESG” in some way or another). And for sure, the hype is there.
But does ESG “work?”
The first challenge in answering the question is the most obvious: How the heck do you even define ESG? How do you compare the efficacy of investing in a clean energy ETF vs. a fund focused on board diversity? The short answer is that you can’t — there are so many flavors of ESG out there, with so many different stated intents, that it’s a bit like asking if real estate “works” as an investment; are we talking houses or row crop farmland or that mall dying up the street?
We can make a few observations about what seems to matter, though, based both on what works objectively and on some deeper work being done in the academic community.
The Easy Win: Risk Management
Lots of research suggests that the “S and G” parts — particularly around public controversy — have a very, very real and predictable effect on portfolios. Moody’s dropped a great piece of research a week ago that found that moderate to severe ESG events generate abnormal stock market losses of −1.3% to −7.5% over twelve months, which represents a loss of approximately $400 million for a typical-sized firm in the study." So, in essence, bad actors get punished because people sell their stock. Fair enough. The staying-out-of-trouble argument is one of the strongest ones in the ESG debate handbook and one that retail investors gravitate towards.
It’s also one of the obvious contributors to any tangible performance delta when comparing two strategies. As a quick example, the ESG version of the S&P 500 index is beating the broad S&P 500 by about 70 basis points so far in 2022, based almost entirely on its avoidance of drawdowns in Meta, Netflix, Paypal, and recently Tesla. If all you wanted to do was stay out of headline trouble, most ESG providers have you covered. For instance, MSCI tracks hundreds of data points from whether a company has chemical safety violations to whether or not a company has persistent ethics issues, like, say, having its staff cheat on ethics tests.
But once you get past the big headline-level risk management stuff, and once you’ve looked at simple financial performance, you run into the wall of intangibles. As we pointed out in the companion article, we’re subscribers to the Cliff Asness theory: ESG investors should expect lower financial returns over the long term simply because they’re constraining their universe. So where does that excess power-as-money go? It goes into all of the intangibles that ESG investors hope are making a difference in the world.
Decent Data: Environmental Measures Have Been (Mostly) Quantified
Most real data on non-financial ESG impacts and outcomes involves climate change. As Jason Saul wrote in the Stanford Social Innovation Review: "Planet isn’t necessarily more important than people, it’s just easier to measure. Investors like measuring things they can put into their models, and carbon is easy to quantify."
The “E” — in terms of carbon emissions — has a solid regulatory reporting framework, outlined through the EPA’s scopes of emissions, indirect, supply chain) for individual companies. Companies measure and report on their scoped emissions, create emissions targets, and share that data with the public so investors and asset managers can use it. Even further, ESG data providers like MSCI and Sustainalytics have mountains of climate data on companies, countries, and industries to work with, inventing ways of thinking about climate impact, like “Implied Temperature Rise.”
There’s some evidence that companies are actively improving by this metric and have correlated future profitability and stock returns, which is great! Although, it should be noted that carbon emission reductions are linked mainly to more efficient practices, which means there’s a bit of a climate-free lunch here. A “good” company that started good and stayed good isn’t necessarily reaping any rewards, but a “bad” company that transitions can simply become a better company, period. (The best work we found on this is Carbon Footprint and Productivity: Does the ‘E’ in ESG Capture Efficiency as Well as Environment? by Garvey, Iyer, and Nash.)
And, of course, carbon is one of the only environmental intangibles we’ve created an actual market for through cap-and-trade carbon allowances, which, thanks to issuers like KraneShares, investors can access directly.
ESG May Really Be About Intangibles
Once we get past the big controversial stuff and climate, everything turns to intangibles, which the only ETF we know of focused exclusively on this set of issues
- the *Sparkline Intangible Value ETF (ITAN )* — calls the Dark Matter of Finance.
Intangible assets are defined as the assets that a company owns that aren’t, well, stuff (patents, brands, trademarks, and so on), and it turns out that most, if not all, of the things that ESG investors care about fall into this category. With the rise of intangible assets over physical assets as the core component of almost all businesses today, and with few effective ways currently available to measure intangibles’ effects, particularly in industries driven by intangibles, this presents a real problem.
Academics love challenging problems with squishy success metrics, so plenty is going on in the ivy halls trying to create frameworks for this. For instance, in 2020’s Equity Investing in the Age of Intangibles, authors Dugar and Pozharny suggested a “composite measure of intangible intensity” across industries that would capture three avenues of intangible value: intangible assets reported on balance sheets (with goodwill excluded to calculate this), innovation capital, and organization capital — all admittedly self-defined terms that might at least be a starting point for trying to discern the value of a company’s intangibles.
If that sounds wibbly-wobbly, that’s the playing field. Intangibles — in the form of non-financial data — were only even mentioned by 22% of the 250 largest companies in annual reports, according to KPMG IMPACT’s 2020 report companies do talk about their intangibles, it’s almost always to tell a positive story. So, for example, while research and development (R&D) isn’t currently included as an “asset” under U.S. GAAP, companies still provide some info that’s genuinely valuable (think of a drug company touting its R&D pipeline), and that taste just makes academics want more.
“Omission of this increasingly important class of assets reduces the usefulness and relevance of financial statement analysis, conducted with book values of assets and equity,” wrote Iqbal, Rajgopal, Srivastava, and Zhao in Value of Internally Generated Intangible Capital this year. They proposed a new accounting method to extract the “real” asset value of R&D specifically by making industry-level assumptions about how useful R&D spending is and then creating amortization of those expenses over time (essentially treating R&D like a kind of Capex). This might be a great idea, but as with most ESG intangible metrics, it strikes us that these attempts to build a math trap for intangibles would only be useful if it were somehow universal.
What does this mean for ESG investing? Larger companies with more resources to focus on data and investor relations can make some noise, but smaller companies either can’t report many of these metrics or face real hurdles if forced. And those smaller companies are often doing the most interesting ESG-ish things like developing new clean energy technologies. In our troll through academia, refactoring the accounting standards doesn’t seem like a solution.
The Jury Is Still out on Measuring Social
Perhaps the most difficult part of ESG to really measure is the “S” — Social. Have you ever read a corporate mission statement that didn’t have some version of “We’re a company made up of people! We love our people!” in it? Human capital is one of the largest assets any company has, and yet, it’s pretty much only carried on corporate books as an expense item, or worse, a set of employment liabilities. But even in the most mundane workforce, not even the most cynical CEO would ever suggest that the quality of the staff actually didn’t matter to the business.
But measuring how “good” your workforce is seems impossible. Like governance, it’s easiest to point out when companies get something horribly wrong (like being sued for union-busting or sexual harassment) than when they do something right, like simply treating their folks like humans.
One approach to calculating human capital investment is discussed in a March 2022 paper, “The Stock Market Valuation of Human Capital Creation,” written by Regier and Rouen and published by the Harvard Business School. They looked at the amount of money spent on people in the past and how that’s correlated with operating income in the present, with the idea that “investing in people” should have a quantifiable return, which should then show up in stock prices. And honestly, the dots don’t quite connect. It turns out analysts hate it when companies spend more on people and there’s so little disclosure to work with. It’s a tough nut to crack.
“Given these limited disclosures, investors face informational challenges when attempting to recognize the variation in firms’ abilities to effectively invest in intangible assets broadly and generate human capital specifically,” Regier and Rouen concluded.
One thing that we do know, however, is that companies where everyone reports being happy tend to perform better. That’s been tested a bunch, but the correlation/causation issues are always thorny. After all, terrible companies tend to have miserable employees primarily because they’re terrible companies.
The Rise of Diversity and Inclusion
With so much increasing focus on how companies perform and the people driving that performance, it’s no surprise that major corporations are spending billions on DEI (diversity, equity, and inclusion) programs.
On the “easy” side, the research keeps piling up that more diverse boards and a more diverse C-suite leads to better company performance — and specifically to higher levels of innovation, according to Corporate Innovation: Do Diverse Boards Help? by An, Chen, Wu, and Zhang, as published in the Journal of Financial and Quantitative Analysis in 2022.
“The benefit of board diversity is more pronounced for firms with more complex operations, more experienced boards, and stronger external governance, suggesting that diverse boards have superior advising capacity. We find evidence to suggest that firms with diverse boards engage in more exploratory innovations and develop new technology in unfamiliar areas,” An, Chen, We, and Zhang concluded.
Diversity is also pretty easy to measure! MSCI has compiled a variety of datasets around diversity, and you can even watch a webcast on the U.S. Racial and Ethnic Diversity Data Set they have compiled. Companies are making definable progress in this arena, too: in the MSCI World Index, which tracks 1,535 companies, 20.4% of board director seats were held by women 2017 compared to 29.0% in 2021. Stepping back even further, the percentage of corporate boards with at least 30% female directors grew from 10% in 2016 to 42% in 2021.
It’s not all a slam dunk for diversity, though: U.S. companies with more than 100 employees are legally required to collect and report data on race, ethnicity, and gender for the U.S. Equal Employment Opportunity Commission, but they aren’t actually required to disclose this information publicly, and it turns out that a lot of them don’t. In 2021, MSCI found that within the MSCI USA Investible Market Index, only 26% of constituents reported race or ethnicity data, while 76% reported gender breakdowns. This often leaves investors with a lot of head-scratching and an inability to measure progress within diversity, and that’s the easier half of the equation.
Inclusion, on the other hand, is difficult to define, much less quantify and measure. It’s much easier to point to a company’s makeup regarding gender, race, ethnicity, age, sexual orientation, or any other statistic you might want to measure than to how all those folks actually feel about their roles. Academics have taken a crack at it by looking at things such as retention because unhappy workers that quit can provide statistical analysis opportunities, but it falls back on once again only being able to measure the negative and not the positive.
So... ESG Sort of Works?
So, where does this leave us? What should you expect out of an ESG allocation?
- In the short term, we remain convinced that many ESG methodologies have (essentially) risk management triggers that will keep you out of trouble and that can create short-term opportunities for outperformance.
- In the medium term, ESG investors may still have an opportunity to outperform from a combination of risk management and the impact of continued ESG flows, which don’t really seem to be going away. Flows still matter, and we suspect that positive flow will create some modest bidding up of ESG leaders.
- In the long term, however, we still think that ESG investors should expect the cost of capital impacts to be at least a potential offsetting drag on performance. Maybe the clean living and flows offset that for decades to come, but also, maybe not.
But even that doesn’t mean that ESG “doesn’t work,” it just means that you need to calibrate what you consider success. While you may be tired of hearing about ESG already, the truth is that we’re in the early innings in our understanding of how the choice to include ESG concerns in capital flows is actually transmitting into the world. There’s some big, in-depth work being done here (we dig A Theory of Socially Responsible Investment, which just dropped from authors Oehmke and Opp, and Sustainable Investing in Equilibrium, a Chicago Booth paper from Pastor, Stambaugh, and Taylor in 2020) but the signs are pretty universally pointing to “actually, it probably makes a difference.”
Perhaps that’s a deeply unsatisfying answer to whether ESG “works” or not, but like everything else related to ESG investing, defining success is as personal a choice as defining ESG.
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