Determining the Nature of ESG Returns


While ESG investing continues to gain in popularity, economic theory suggests that if a large enough proportion of investors chooses to avoid “sin” businesses, the share prices of such companies will be depressed. They will have a higher cost of capital because they will trade at a lower price-to-earnings (P/E) ratio.

Thus, they would offer higher expected returns (which some investors may view as compensation for the emotional “cost” of exposure to what they consider offensive companies). Academic research I reviewed in a recent article has confirmed that the evidence supports the theory.

It is logical to expect that investors shunning certain stocks should lead to those stocks having higher future returns, but it is also logical to hypothesize that companies neglecting to manage their ESG exposures could be subject to greater risk (that is, a wider range of potential outcomes) than their more ESG-focused counterparts. Again, academic research confirms that the evidence supports this hypothesis.

Thus, when it comes to ESG investing, it appears that there are two opposing forces at work: lower returns and lower risk. One hypothesis is that the two might offset each other in terms of delivering risk-adjusted returns. Andre Breedt, Stefano Ciliberti, Stanislao Gualdi and Philip Seager contribute to the literature on ESG investing with their July 2018 study, “Is ESG an Equity Factor or Just an Investment Guide?

Factor Or Guide?

They sought to determine the impact that ESG investing has on risk-adjusted returns, employing asset-pricing models for benchmarks. They used the MSCI ESG database, which contains monthly ratings for 16,799 worldwide companies. The study covers the period January 2007 until October 2017.

Following is a summary of the authors’ findings:

  • ESG scores might have a developed-region bias; emerging markets have lower ESG scores than developed markets.
  • ESG score is negatively correlated to the size (SMB) factor and slightly positively correlated to the low-volatility (LV)/low-beta (LB) factors. Large-cap stocks and low-volatility/low-beta stocks have higher ESG scores.
  • An equity-market-neutral portfolio constructed with ESG ratings as a predictor shows flat worldwide performance. (Performance is marginally positive in Europe but negative in the United States. None of the results, however, is statistically significant.)
  • The portfolio’s total performance can be explained by negative SMB exposure, negative momentum (UMD) factor exposure, and positive LB exposure.
  • The portfolio’s remaining unexplained performance is flat.
  • The environmental (E) and social (S) scores do not contribute to performance and the positive benefit of the governance (G) score is explained well by its correlation to the profitability factor.

The authors concluded their results indicate that “any benefit from incorporating ESG credentials into a portfolio is already captured by other well-defined and known equity factors. An ESG-tilted process does not deliver higher risk-adjusted returns.”

While the evidence from Breedt, Ciliberti, Gualdi and Seager’s study demonstrates that ESG information yields no additional benefit, importantly, neither does it negatively affect risk-adjusted returns. It does, however, allow investors to express their social views through their investments without any penalty, at least in terms of risk-adjusted returns.

This commentary originally appeared August 17 on

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Larry Swedroe, Director of Research

Director of Research

Larry Swedroe is director of research for the BAM ALLIANCE.

Previously, Larry was vice chairman of Prudential Home Mortgage. Larry holds an MBA in finance and investment from NYU, and a bachelor’s degree in finance from Baruch College.

To help inform investors about the evidence-based investing approach, he was among the first authors to publish a book that explained evidence-based investing in layman’s terms — The Only Guide to a Winning Investment Strategy You’ll Ever Need. He has authored six more books:

What Wall Street Doesn’t Want You to Know (2001)
Rational Investing in Irrational Times (2002)
The Successful Investor Today (2003)
Wise Investing Made Simple (2007)
Wise Investing Made Simpler (2010)
The Quest for Alpha (2011)

He also co-authored four books: The Only Guide to a Winning Bond Strategy You’ll Ever Need (2006), The Only Guide to Alternative Investments You’ll Ever Need (2008), The Only Guide You’ll Ever Need for the Right Financial Plan (2010) and Investment Mistakes Even Smart Investors Make and How to Avoid Them (2012). Larry also writes blogs for and Index Investor Corner on