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E-MailByung Hyun Ahn is a Senior Researcher at Dimensional Fund Advisors; Panos N. Patatoukas is a Professor and the L.H. Penney Chair in Accounting at the University of California Berkeley Haas School of Business; and George S. Skiadopoulos is a Professor at Queen Mary University of London and the University of Piraeus. This post is based on their article forthcoming in The Accounting Review. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) by Lucian A. Bebchuk and Roberto Tallarita; How Much Do Investors Care about Social Responsibility? (discussed on the Forum here) by Scott Hirst, Kobi Kastiel, and Tamar Kricheli-Katz; and Does Enlightened Shareholder Value Add Value? (discussed on the Forum here) by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita.
What is the link between changes in ESG scores and future stock performance? The question is a critical one as investors and firms are increasingly mindful that environmental, social, and governance (ESG) issues can have a material impact on corporate value creation. The need to identify material ESG issues has fostered an ecosystem of standard-setting organizations, rating agencies, and index providers. The materiality framework and industry-specific disclosure standards developed by the Sustainability Accounting Standards Board (SASB) are part of the foundation of this ecosystem.
Prior research applies SASB’s framework to distinguish financially material from immaterial ESG issues and finds that the portfolio of firms with improving ratings on material issues outperforms against a set of selected pricing factors. With respect to the source of portfolio outperformance, or alpha, this research argues that changes in a firm’s material ESG score contain ‘hidden information’ about future firm performance that has not already been priced. The ‘hidden information’ embedded in ESG scores, the argument goes, is drowned out by noise when pooling material and immaterial issues.
The idea that material ESG scores embed hidden information that could help investors select stocks with higher future abnormal returns has proven to be a highly effective narrative for the marketing of a host of ESG scoring models and indices. Index fund managers and index providers often cite evidence of material ESG alpha as de facto evidence of the value of SASB’s materiality framework.
Sorting out causation from correlation is critical in the debate of the source of material ESG alpha. Simply put, the issue is that material ESG scores do not change in a vacuum. Companies with improving material ESG scores may differ in terms of fundamental characteristics that are systematically related to subsequent stock return performance. In the absence of an exogenous source of variation in ESG scores, researchers need to rely on observable characteristics to control for economic forces that simultaneously determine material ESG score changes and stock returns.
Building on this idea, our paper provides a fundamentals-based perspective on why firms with improving material ESG scores outperform. More financially established firms—firms with larger size, lower growth, and higher profitability relative to their sector—are associated with subsequent improvements in their material ESG score. This fundamental association dictates that the benchmark model of normal performance should also account for portfolio exposures to fundamental determinants of stock returns before attributing stock outperformance to improving material ESG scores.
Our evidence calls attention to the issue of correlated omitted fundamental factors in the debate of ESG alpha. Indeed, we find that the materiality portfolio does not generate alpha after we explicitly account for its exposure to profitability and growth factors. Our evidence further shows that one could use a simple portfolio sort based on fundamental characteristics to mimic not only the return performance, but also the overall ESG score of the materiality portfolio. A relevant implication is that investors could target an overall ESG score by simply selecting portfolio stocks on fundamental firm characteristics.
As an external validity test, we evaluate the performance of the Bloomberg/SASB index family powered by State Street’s ‘Responsibility Factor’ (R-Factor), which is aligned with the SASB materiality framework and draws from alternative ESG data sources. Our evidence shows that the Bloomberg/SASB indices do not generate abnormal returns against style-matched passive benchmark indices that do not incorporate ESG considerations. These external validity tests show that our inferences extend beyond our own construction of the materiality portfolio.
To be clear, our evidence does not disprove the potential for sustainability investments to generate value for shareholders and positively impact other stakeholders. Our paper simply raises questions about the incremental relevance of commercially available ESG scoring models in terms of uncovering hidden information that goes beyond what one could identify through corporate financial statements.
Global ESG funds and portfolios have grown into a multi-trillion dollar investing force. Looking ahead, capital flows due to changes in the fraction of ESG-motivated investors and their tastes could impact the future realized performance of stocks added to or deleted from sustainability portfolios. In addition, active investors could identify alternative ESG mappings and scoring models that would give them at least a temporary edge over other investors. Though it is possible that alternative materiality portfolios may exhibit future abnormal returns, it is important to remember that portfolio alphas measure wealth transfers across transacting investors and not social welfare creation.
From the perspective of social planners, alpha generation is not a measure of the efficacy of the sustainability standard setting process. Perhaps the time is ripe to evaluate the real effects of sustainability reporting. On the part of ESG index providers and fund managers, our evidence underscores the need for transparency with respect to the performance and ESG characteristics of portfolios marketed as sustainable vis-à-vis properly identified benchmarks. More transparency could help investors make informed capital allocation decisions and invest in alignment with their values.
