Responsible/ESG Investing

Let me preface this post by saying that I have nothing against social responsibility or having social responsibility reflected in an investment portfolio.

I read an article in Investment Executive recently discussing the evidence that Responsible Investing (RI) leads to as-good or better returns compared to traditional investing. The article compares the performance of well-known indexes to demonstrate the long-term benefits of RI. In the article, long-term seems to be defined as the trailing 10-years. In my opinion, and the opinion of most researchers, a 10-year period is insufficient to draw any conclusions.

It is true, as the article states, that the MSCI ACWI ESG Leaders Index has beaten the MSCI ACWI index since 2007, when the indexes became available. The performance difference has been 0.22% per year on average. However, this difference is not due to the responsible nature of the companies in the index.

The difference in returns between diversified portfolios is almost completely explained by exposure to certain types of securities. The characteristics that define those certain types of securities are called factors. Factors explain the differences in returns between diversified portfolios extremely well. A factor is a long-short portfolio where the portfolio is long one side of a characteristic and short the other. For example, the size factor is determined by subtracting the returns of large stocks from the returns of small stocks. If small beats large, the factor exhibits a performance premium.

Currently there is a five-factor model that has been published by Eugene Fama and Ken French, the men who pioneered factor research in the 1990s. The factors in the model are market (market minus the risk-free asset), size (small stocks minus large stocks), relative price (value stocks minus growth stocks), profitability (stocks with robust profitability minus stocks with weak profitability), and investment (stocks that invest conservatively minus stocks that invest aggressively).

We can use statistical analysis to see how much a portfolio’s return is explained by these known factors. It is probable that an ESG (environmental, social, governance) index is offering naïve factor exposure. In other words, by targeting ESG companies the index is likely getting exposure, by accident, to known factors.

To put to rest the idea that an ESG index is inherently better I have run five-factor regressions on an ESG index compared to a total market index using Ken French’s data. What we should expect is that exposure to the factors will explain the return differences between the ESG index and the total market index.

In the following table, the coefficients tell us how much loading the portfolio (index) has to each factor, and the t stat helps us to understand if the coefficient is statistically significant. A t stat over 2 indicates statistical significance.


In this case we see that most of the factor exposure is statistically insignificant and small, which we would expect for a total market index, except for RMW, which is a little bit larger and statistically significant. RMW is the profitability factor. This is indicating that the ESG index has more exposure to stocks with robust profitability than the market.

The research shows that more profitable stocks tend to outperform less profitable stocks over the long-term. The RMW premium over the time period in question (12/1/2007 – 7/31/2018) was 3.34%. That is, more profitable stocks beat less profitable stocks by 3.34% per year on average over the period.

We can estimate the amount of additional return that we would expect from RMW exposure for each index by multiplying the regression coefficient by the premium. Multiplying the difference in coefficients (0.23 for ESG minus 0.11 for total market) by the factor premium we get an expected performance difference of 0.40% per year on average.

Put simply, when we adjust for factor exposure, the ESG index has actually done a little worse than we would expect it to compared to the total market index.

The article that I am responding to also offers that the Jantzi Social Index, an index of socially responsible Canadian stocks, has beaten the S&P/TSX 60 since inception of the index in 2000. That is true.

Ken French does not publish factor data for Canadian stocks. AQR does have Canadian factor data, but they look at slightly different factors. They do not look at Profitability (RMW) or Investment (CMA). They add in QMJ (quality minus junk) which does include profitability among other characteristics. We will look at a four-factor regression including market, size, relative price, and quality. I was only able to obtain total return data for the Jantzi Social index back to May 2009, but the regression results should still be informative.


In this case we see similar negative loading to SMB for both indexes, which we would expect as these are both large cap indexes. We see slight loading to value, statistically significant for the Jantzi and insignificant for the TSX 60. The big statistically significant difference comes from QMJ, which for the sake of discussion is very similar to RMW. A relatively large and statistically significant loading to highly profitable stocks would easily explain the higher returns of the Jantzi index.

So far, we have seen that the higher returns of an ESG index can be attributed to factor loading as opposed to the inherently better returns of ESG companies.

The article cites an academic study showing that ESG mutual funds beat their benchmark 63% of the time. That study looked at a handful of Canadian mutual funds included in the Responsible Investment Association listings. The study, as far as I can tell, does not address survivorship. ESG investing aside, this study conflicts with the massive body of evidence that active mutual funds typically fail to beat their benchmark index.

I won’t recreate the study with a correction for survivorship for this post, but consider that over the trailing 10-year period about 50% of Canadian mutual funds have closed down, likely due to poor performance. Basing a study on funds currently in existence ignores all of the funds that have closed. The surviving funds are likely to have done better by nature of having survived, but that may well have been due to luck. I suspect that a survivorship correction would drastically change the results of this study.

The article also cites a report from MSCI which found that high ESG-rated companies tend to be more profitable with higher dividend yields and lower idiosyncratic tail risks. We have proven this to be true, at least the profitability part, with regression analysis. The problem for investors is that if you want to maximize risk adjusted returns through exposure to factors, including profitability, then ESG investing is a very inefficient and potentially inconsistent way of getting it.

Not to mention that the fees on ESG funds tend to be high. In the case of index funds, an ESG index fund will typically carry a higher fee than a total market fund. XEN, the Jantzi Social Index ETF has an MER of 0.55% while VCN, the Vanguard FTSE Canada All Cap Index ETF has an MER of 0.06%. Most ESG funds are actively managed, and carry fees well over 2%. The notion that an ESG screen will magically allow actively managed funds with high fees to beat their benchmark is not sensible.

Finally, investors need to understand that buying the securities of a company on the secondary market does very little to impact that company’s future. It is perfectly reasonable to feel guilty profiting from a company that engages in business that you do not agree with, but it is important to understand that owning shares in a company does not benefit the company.

As I mentioned at the beginning, I have no problem at all with ESG investing as long as it is done for the right reasons. The reason to be an ESG investor should be that it makes you feel happy. There should be no expectation that an ESG investment will outperform a non-ESG investment with similar exposure to the factors that explain returns.

As opposed to buying ESG investment products it might make sense to optimize a portfolio for low costs, diversification, and factor exposure – all things that an ESG portfolio typically gives up – and donate money directly to causes that are important to you.