The most important paper to understand ESG investing

Brad Barber is fantastic. Twenty years ago the UC Davis Professor published the monolithic “Trading is Hazardous to Your Wealth” with Terrence Odean. This paper has become the go-to resource for everyone who wants to understand why trading leads to lower performance and it is one of the papers that I have referred to most often in my career.

Now, he seems to have done it again. Together with Aday Morse and Ayako Yasuda, he estimated how much performance investors are willing to forego to invest in socially responsible investments. One common complaint about ESG investing is that it is unclear if it leads to similar, higher or lower returns than traditional investment approaches. I have written several times about that issue before, but the fundamental question really is not if ESG investing has returns that are different from traditional investments. It is whether investors care about these differences?

One of the most common reactions I get from traditional investors on ESG investing is that it may well lead to lower returns than traditional investments, if not in recent years than possibly in the future. If ESG investing is truly an approach to reduce exposure to certain risks then green investments should have lower expected returns in the long run simply because they are less risky. The argument of many traditional investors is that it surely would be better to invest in traditional portfolios that maximise returns and use the higher returns to do good in the world through philanthropy. That would be the rational thing to do.

But people are not rational. Investors who really care about the environment or societal problems would have a moral conflict if they knew they had stocks of fossil fuel companies etc. in their portfolios. And every financial adviser who works with investors knows that they are willing to forego a lot of returns for the benefit of being able to sleep well at night.

With a simple, yet ingenious approach, Brad Barber and his colleagues managed to estimate how much return investors are willing to forego to sleep well at night. They looked at 4,659 venture capital (VC) and growth equity funds from 1995 to 2014. Out of these VC funds, they isolated 159 funds that were impact-investing funds. Impact investing is even stricter than traditional ESG investing insofar as creating a positive societal impact with your investments is a mandatory part of the investment profile. Greenwashed traditional investments or investments in companies and projects that are beneficial to society by coincidence (like health, education or clean energy) are not impact-investing funds. Thus, we do not have to worry too much about all the grey areas of ESG investing in the interpretation of this study.

The second advantage of their study is that it looks at private equity vehicles instead of public equities or mutual funds. This has the advantage that investors commit their capital at the beginning of the investment period and then are locked up for several years. So, we don’t have to worry about investor capital flows and can compare the investments in impact-investing VC funds with traditional funds closed at the same time.

Given these advantages, the researchers find that ex post, impact-investing VC funds have IRRs that are on average 4.7 percentage points lower than traditional funds. That is a lot. Yet, what really matters is if investors are willing to forego such high returns ex ante (i.e. when they make their investments).

It turns out that investors are willing to cut impact-investing funds a lot of slack. Our first chart looks at the excess IRR relative to the median VC fund performance investors are willing to forego in different regions. In Asia, investors are not willing to forego any performance in an impact-investing fund, while in North America investors are on average willing to forego about 1.3% return per year. In Europe, the willingness to pay for impact-investing funds is almost three times as high and investors are willing to forego about 3.6% per year in return for the benefit of having funds in their portfolios that match their values. Over a ten-year investment period that is a cumulative return of 42% left on the table for the ability to sleep well at night.

Amount of return deficit that investors are willing to accept in impact-investing funds

Source: Barber et al. (2019).

If we look at the types of investors that are most willing to forego returns for the benefit of investing in impact-investing funds, we see that institutions that face public pressure about their investments are willing to forego more returns. Banks, insurance companies and public pension funds are increasingly in the spotlight and targeted by divestment campaigns to sell existing holdings in unsustainable investments. Because of this public accountability, these institutions are often willing to invest in ESG investments and impact-investing funds even if it means giving up substantial returns. The reduced political pressure is worth a lot for these institutions.

It is important to note that this trend towards increased public accountability of institutions is, if anything, accelerating. In Europe, definitions and benchmarks of what constitutes a sustainable economic activity are currently under development and in a few years’ time, all institutional investors will have to report their investment performance relative to these definitions and benchmarks. As always, once deviations become transparent, the pressure to adhere to these higher standards of investments will increase and institutional investors in Europe will invest even more in ESG assets.

Amount of return deficit that investors are willing to accept in impact-investing funds

Source: Barber et al. (2019).

Finally, the study also looks at the kind of topics that investors consider important impact investing topics. The chart below shows that investments that try to improve the environment, fight poverty or help minorities and women are highly priced amongst investors while social infrastructure (hospitals, schools etc.), regional development or funding for small and medium enterprises command only a small premium.

Amount of return deficit that investors are willing to accept in impact-investing funds

Source: Barber et al. (2019).

I can already hear the ESG sceptics complain that this only proves that people are stupid. Why would anyone willingly give up so much return? But the problem is not that people are irrational. They are just different and have different values and preferences. On Wednesday, I will write about one of the most fundamental mistakes economists make in their models, namely to assume that there is an average investor that can be used to understand the market. ESG investing is a prime example that this assumption of average investors is wrong. Only if you accept that there are different groups of investors with different preferences can you understand ESG investing and other trends in the world today.