Investing in ESG stocks has been heating up in recent years, but the firms that provide the data may be the only ones that are winning in the ESG revolution. In a recent report, Factor Research examined the ESG data from one provider and analyzed stock performance.
Q3 2020 hedge fund letters, conferences and more
Author Nicolas Rabener found that the stocks with the worst ESG rating in the data set he looked at outperformed over the last 12 months. This suggests that proponents who claim ESG boosts stock prices may not be seeing the whole story when it comes to the data.
The ESG data ecosystem
Rabener explained that the "ESG ecosystem" has three categories of players. They are the data providers, data consumers like asset managers and index providers, and asset allocators. However, he argues that there's only one winner in ESG investing, and that's the data providers that sell ESG ratings.
He explained that demand for anything related to ESG allows asset managers and index providers to charge more for ESG products than for non-ESG ones. These products also come with added costs like buying ESG data, hiring quant analysts and marketing. Asset managers do benefit by reducing the emphasis on short-term performance because they can tout the high ESG ratings of their stocks even though they might be underperforming.
"The asset allocators, and ultimately their clients, are most likely the losers as they are financing this 'feel-good' ecosystem, with little evidence supporting the idea that ESG investing generates consistent outperformance," Rabener wrote.
Opimas expects the ESG data market to grow 20% and hit $1 billion next year. Meanwhile, assets under management in ESG exchange-traded funds have been surging as well, rising $38 billion to surpass $100 billion in the first eight months of this year, according to ETFGI data. Rabener advises investors to be cautious when evaluating ESG data on stocks because of the strong momentum of the ESG industry.
Are companies gaming the ESG system?
Rabener reports that the average ESG rating has doubled from 25 to 50 since 2000. He said ESG proponents may hope that all companies have become better corporate citizens, but he believes that's "too naïve." Rabener believes the increase in the average ESG score is due to the availability of more data and "stocks being evaluated from today's perspective."
He explained that in the past, many data providers excluded stocks with low ESG ratings, but that has changed in recent years because it results in major tracking errors. He noted that most of stock market returns since 2010 came from the FAANG stocks (Facebook, Amazon, Apple, Netflix, GOOGL/Alphabet). If one of those were excluded due to a low ESG rating, returns would've been much lower.
Another problem with the data is weighting stocks by their ESG scores, so most data providers incorporate ESG on a sector level. While that minimizes tracking errors, it results in exposure to less attractive sectors like energy.
Analyzing ESG data for stocks
To analyze the data set, which covers 790 stocks, Rabener separated them into quartiles based on their ESG ratings and then calculated ratios based on their most recent financial data. He found that companies with high ESG ratings usually had lower earnings and sales growth rates, although they had higher operating margins than stocks with low ratings. Rabener added that companies with high ESG ratings tend to be more profitable but also more leveraged.
In calculating the performance of stocks with high and low ESG ratings, he found that stocks with the lowest ESG scores tended to be more volatile but also generated the highest returns. However, he noted that he only looked back one year.
Rabener noted that there isn't much research that suggests ESG generates excess returns in the long term. Thus, the focus in marketing ESG is on risk management ratings. Many argue that companies with low ESG ratings have a higher risk of corporate disasters, like BP with the 2010 oil spill in the Gulf of Mexico.
Rabener argues that ESG ratings should be view at like credit ratings, which are a lagging indicator of corporate riskiness.
