Last week, I wrote about a set of laboratory experiments with financial professionals from the United States and Germany that showed that if presented ESG data, financial professionals were willing to invest more in a stock both for themselves and their clients.
Long-time readers will know that I love lab experiments because they allow us to test hypotheses in a controlled environment without all the distracting noise that is part of day-to-day investment decisions. But critics sometimes claim that just because people act one way in a lab experiment, they don’t necessarily do the same in the real world. While that is a risk (though typically not a big one), I came across a study of US fund managers that tests how they react to ESG news and data in their real life investment decisions.
A group of researchers from the University of Exeter, the University of Edinburgh and the University of Miami looked at the portfolios of 1,870 actively managed equity funds in the United States and how they reacted to ESG news flow in 1,519 US stocks between 2007 and 2017.
If as in the lab experiment, investment professionals invest more in stocks that publish positive ESG data, then the stocks with positive news flow on ESG topics should experience an increase in allocation even if there is no conventional news. And that is exactly what seems to happen. A one standard deviation increase in ESG news (roughly pushing a stock from the bottom quartile of all stocks in terms of ESG news to the top quartile) leads to an average increase of that stock by 0.38% to 0.53% in a fund’s portfolio over the subsequent three months. If that doesn’t sound like much, then realise that over the entire universe of tracked funds in the study that would amount to $124.5m to $181.0m in additional investments. This means that for the average stock in the sample, the ownership by active fund managers increases by 1.12 percentage points.
Interestingly, the study could also shed some light on why fund managers react to positive ESG news and they found two reasons. First, they noticed that funds that cater more to investors that are more aware of ESG investing like retail investors increase their holdings of stocks with positive ESG news flow more than funds that cater more to conventional investors. Thus, there is some signaling involved in that a fund manager wants to show his or her clients that ESG is part of the fund management process. And the funds that do that get handsomely rewarded for it. The increase in allocation to stocks with positive ESG news flow leads to c.$3.3m in additional inflows in the fund in three months and c.$3.8m if it is a stock in the top ten of the fund’s holdings (which are typically more prominently presented to clients).
But, the second reason is more interesting. Because stocks with lower ESG risks tend to perform better, an improvement in the ESG news flow is typically associated with better stock performance in the twelve months after. And that means those fund managers who increase their holdings in stocks with positive ESG news flow tend to perform better than fund managers who don’t. And this seems to be something that the best fund managers know because it is particularly the top quartile fund managers that increase their holdings in stocks with the positive ESG news flow. And the result is that these fund managers can increase their outperformance over bottom quartile fund managers for a couple more quarters.