The case for ESG as a driver of alpha

Xponance's Sumali Sanyal explores the contribution of ESG factors to performance

ESG factors remain a strong driver of investment returns when other elements are stripped out, according to a study from asset manager Xponance.

Sumali Sanyal, senior portfolio manager of systematic global equities at Xponance, conducted research that isolated the contribution of ESG factors from other performance drivers such as stock selection.

Sanyal noted one of the arguments against the existence of ‘ESG alpha’ is that non-ESG factors are responsible for relative performance.

For instance, positive ESG exposure to large-cap growth companies in the technology sector, and an underweight to value-tiled ‘brown ESG’ sectors such as energy, industrials and utilities, can actually be explained by differences in sector, industry and investment style.

However, Sanyal’s study aimed to look at the alpha potential of ESG characteristics not fully captured by a portfolio’s sector, industry or risk factor exposures.

Using Sustainalytics ESG Risk Scores, she constructed two portfolios that maximised and minimised ESG scores, while matching the key risk characteristics, sector and industry weights of the S&P 500.

The research revealed there was a positive ESG return premium between the performance of the portfolios with lower ESG risk versus those with higher ESG risk.

The more active the portfolio, the higher the potential for alpha using ESG characteristics.

The study also found there were opportunities from market mispricing of ESG value potential, for example, where there is incomplete disclosures of firms’ ESG efforts or because investors have similar opinions of the value of ESG.

Why is there an ESG return premium?

Focusing on the ‘E’ or ‘environmental’ in ‘ESG’, the ESG return premium can be attributed to a combination of risk mitigation and opportunity capture, said Sanyal.

“Risks stem from current negative externalities that a company may be forced to address to protect itself in the future. For example, carbon emitters and other polluters may have to bear disproportionate costs from adverse community action, customer sentiment, regulation, shareholder activism, and reputational damage.

“Proactive risk mitigation could mitigate these costs and lessen return volatility. Environmental opportunity capture relates to capitalising on business and innovation opportunities generated by current environmental concerns. Such efforts could result in higher future profits.”

‘Not a one-sided story’

However, she added that “the story…is not one-sided”, as there are concerns about the relationship between ESG and shareholder value.

ESG efforts cost money, and investment in them can bring diminishing returns. A bigger board might hamper timely decision-making, or tighter remuneration policies could prevent a firm hiring the best staff, for example.

“In essence, ESG efforts may impact the fundamental elements of shareholder value – profitability, future growth, and risk – in myriad ways,” said Sanyal.

“These arguments create concerns about the positive alpha potential of ESG and underscore the need to consider accurate and material ESG factors when assessing companies to invest in.”