Once again: ESG investing is not about performance

There still are people out there who claim that ESG investing leads to outperformance. Meanwhile, there are still hardcore believers in modern portfolio theory that think ESG investing must underperform because it is optimisation of portfolios with additional constraints. Both are wrong.

I have addressed the nonsense that ESG investing equals portfolio optimisation with constraints in this post and won’t bother dealing with that claim here. But the people who believe that ESG investing must underperform due to its constraints have done me a favour by trying to prove that ESG portfolios underperform – and failing to do so.

I do not want to claim that Lars Homuf and Gül Yüksel truly believe that ESG portfolios must underperform, but in their new study, they started with the theoretical assumption that since ESG portfolios are optimised under additional constraints, modern portfolio theory says that ESG portfolios should underperform. Then, they set out to do a meta-analysis of studies on the performance of socially responsible portfolios. Settling on 153 studies with more than 1,000 results for funds, stocks, and bonds they find an average outperformance of socially responsible portfolios over the market of 1.9% per year with some 44.9% of results showing an outperformance.

But the problem with this unconditional performance is that socially responsible investments are strongly geared towards technology and other sectors that have done particularly well over the last decade or so, while energy and mining have done rather poorly. Once studies correct for systematic factor exposure, the authors could not find any performance difference between conventional portfolios and socially responsible portfolios. That means no outperformance, but also no underperformance of socially responsible investments. They do find that socially responsible portfolios do outperform some regional markets which is possible, but not the global market.

And that is exactly what I would have expected. If socially responsible investing or ESG investing is simply a way to capture risks that are not priced in financial markets, you wouldn’t expect any outperformance in the long run, but you would expect to have lower drawdowns in case these risks materialise. The authors of the study claim that the lack of performance difference between socially responsible investments and conventional investments could be due to the short time period used for the measurement and the recent boom in socially responsible investments that might have pushed green stocks and bonds to excessive valuations. Maybe. Or maybe their argument of “we simply haven’t looked long enough” is the same argument that value investors have been using for two decades when they say that the US stock market is overvalued and must underperform. At some point, the ‘long-term’ might be indistinguishable from ‘never’.