What is ESG? It depends on who you ask

TSAI

Introduction

In recent years, global investors’ awareness of the connection between investment decisions and broader environmental and social issues has continued to grow. In addition, investors are increasingly concerned about how companies’ environmental, social and governance policies and risks may affect the future performance of these companies’ stocks. These dynamics have led to the growing popularity of ESG investing, which is investing based on environmental, social and governance characteristics.

Investors can incorporate ESG into their processes in several ways. First, they can incorporate ESG investing into their portfolios by overweighting assets with positive ESG characteristics (and underweighting or excluding assets with negative ESG characteristics), or investing in funds with positive ESG characteristics. Investors can also incorporate ESG into their risk management processes by actively managing and monitoring ESG-related risks of their portfolios and managers. Finally, investors can invest in asset management companies that themselves operate with good ESG practices at the corporate level.

In the first case, it is reasonable for hiring ESG-aware or ESG-focused managers to want to be able to answer the following questions:

My managers say they are incorporating ESG into their processes, are they really doing so?
Can I quantitatively measure my manager and portfolio’s exposure to ESG?

In this Street View, we explore the current ESG data available to allocators for quantitative analysis and the potential challenges that arise from this. We begin by highlighting that ESG ratings data vary widely across providers, we explore why this is the case, and we conclude with a summary of the practical implications for allocators seeking to use this data to enhance investment decisions and build better portfolios.

ESG Ratings Are Everywhere

In the investment industry, it is well known that ESG ratings vary across providers. Dimson, Marsh, and Staunton found that “companies with high [ESG] scores from one rating agency often receive mediocre or low scores from another” and that there is little correlation between ESG ratings from different providers. 3 The Barclays System Equity Research team commented on the dispersion of ESG ratings in their report, Learning from Disagreement: Is the Dispersion of Corporate ESG Rankings Across Providers Informative?

Unlike financial metrics such as company earnings and credit default risk, ESG attributes are often intangible and qualitative in nature. More importantly, there is a lack of uniform definitions of the underlying measures. The subjectivity and ambiguity that the term ESG attempts to capture leads to large differences in ratings across different providers.

We observed a high degree of implicit divergence when analyzing correlations across three sample ESG index providers:

• MSCI’s ESG Leaders and SRI Indexes;
• S&P 500 ESG Index; and
• Dow Jones Sustainability US Composite Index.

These indices are long-only and focused on US equities, so we first subtracted the returns of US equities to isolate the excess returns of these indices. We then assessed the correlation between their excess returns. If the correlation is high, it indicates that ESG definitions are relatively consistent across providers.

The value and momentum factors exhibit high excess return correlations, suggesting that different index providers agree on how to measure value and momentum. The agreement is particularly impressive for the value factor, as there are many ways to define value (e.g., price-to-book ratio, dividend yield, and earnings yield), and the correlations between these methods can be very low. The value index we use in this correlation matrix combines multiple value metrics to determine a stock’s value exposure, suggesting that index providers appear to agree on how to measure value (by combining multiple definitions) to the extent that their excess return correlations remain very high.

Conclusion

In summary, ESG ratings vary widely across providers. Characteristics of the provider ratings methodology and/or differences in weightings between ESG components may contribute to this dispersion in ratings. Given this dispersion, what are the possible implications for asset allocators who want to quantitatively measure their ESG exposure?

Using one of these ESG indices to measure manager or portfolio performance (by measuring metrics such as correlation, beta, excess return, or tracking error) is not robust because the results of that analysis depend on the index used, much more than if one were to choose between indices tracking U.S. large-cap stocks (e.g., the Russell 1000 vs. the S&P 500) or equity style indices (e.g., the MSCI U.S. Momentum vs. the Russell 1000 Momentum).

Just as relative performance statistics are particularly sensitive to ESG benchmarks, exposure to ESG using holdings-based analysis may also be sensitive to ratings providers. That is, if one uses “out-of-the-box” ESG ratings for individual securities and aggregates them to the portfolio level to understand a fund’s ESG exposure, that analysis will also depend on the provider used for the ratings and therefore may produce different (and potentially directionally different) results.