Institutions are increasingly skeptical of ESG ratings, and recent research highlights unintended consequences of incorporating ESG metrics into portfolios.
Analyzing stock data from 1998 to 2020 and ESG data, two approaches were evaluated. First, strategies based solely on returns, without considering ESG scores, resulted in higher ESG scores compared to ESG-based strategies. Second, prioritizing stocks with the highest ESG scores did not yield the most efficient portfolios in terms of risk-adjusted returns. While ESG-inclusive portfolios showed higher returns, they also exhibited greater volatility.
The inherent noise in ESG metrics introduces estimation risk, leading to suboptimal portfolio allocation. Explicitly targeting ESG metrics often results in portfolios economically and environmentally inferior to market allocation. Disagreement among ESG ratings agencies further compounds the issue, as does the uncertainty associated with ESG metrics, which has been shown to lower financial returns.
In essence, the pursuit of broader impact through ESG is commendable, but the devil lies in the details: the measurement and selection of metrics are crucial. The absence of clarity and consensus on ESG metrics introduces significant noise into investors’ portfolio decisions, akin to attempting to hit a moving target and potentially creating chaos in the process.
In a survey of 1,500 individuals, we asked them to rank 10 ESG topics to understand how the average American perceives these matters. While we can only provide relative rankings, our findings show no statistical evidence suggesting that individuals believe companies should prioritize objectives other than maximizing shareholder value, once their own ranking of ESG issues is considered.
Interestingly, among those who prioritize issues like climate change, they acknowledge that it may not be a primary objective for companies. Instead, respondents tend to prioritize company objectives such as paying a living wage even higher than their personal rankings of it. This suggests that the justification for active ESG policies based on the belief that companies should do more is actually a reflection of individuals’ own preferences projected onto companies.
In a randomized experiment, we provided some respondents with information about the costs of renewable energy, while others received no information. This aimed to assess the impact of information on attitudes toward ESG. Interestingly, those exposed to information about the costs of renewable energy showed decreased support for renewable policies, highlighting overlooked costs.
This disconnect between personal and organizational ESG objectives, coupled with the complex ESG scoring landscape, underscores the risks of relying heavily on these scores for investment decisions.
A key takeaway is the importance of a balanced approach. While ESG metrics offer valuable insights into a company’s societal impact, they should complement, not replace, traditional financial metrics. Investors should exercise caution against overemphasizing ESG at the expense of established measures.
Tran Dung/ATES GLOBAL
Source: Fortune
