Is there an opportunity cost of responsible investing?

Bu LARRY SWEDROE

Sustainable investors pursue not only financial return but also ethical satisfaction. The trend toward sustainability has boomed in recent decades. Along with the increased interest by investors has been increased attention by researchers on the impact of sustainable strategies on the risk and returns of a portfolio. Li Cai, Ricky Cooper and Di He contribute to the sustainable investment literature with their study Socially Responsible Investing and Factor Investing, Is There an Opportunity Cost?, published in The Journal of Portfolio Management Quantitative Special Issue 2022, in which they examined factor investing in the presence of an environmental, social and governance (ESG) screening overlay.

The authors analyzed performance of responsible investing strategies focusing on five asset pricing factors that are well accepted in the literature and included in asset pricing models: size, value, profitability, investment and momentum. They constructed single-factor and multifactor portfolios as benchmarks for comparative study with sustainable investment portfolios — testing whether performance differences for unscreened benchmark factor portfolios and ESG-screened factor portfolios are statistically or economically significant.

Cai, Cooper and He tested both positive screening (which allows companies with nonnegative ESG scores) and negative screening (which eliminates ESG-negative companies but does keep non-rated companies). And as you might expect, the results of the two methodologies were quite different. They used the Kinder, Lydenberg and Domini (KLD) Stats database for ESG scores. Prior to 2001, KLD covered about 650 firms; it then expanded to about 1,100 companies in 2001 and 2002. After 2002, KLD provided ESG data for around 3,100 firms. Their data sample spanned the period 1992-2017. To account for sector biases in ESG scores, they also considered industry-neutral scores.

In order to closely mimic the majority of institutional- and retail-managed money, they built long-only investment benchmark portfolios based on factor score sorting, creating two levels of factor exposure: Top 50 and Top 20. Top 50 contained the top 50 percent of the universe as ranked on that particular factor, and Top 20 contained the top 20 percent. Following is a summary of their findings:

Positive screening for ESG greatly cuts the universe size (reducing diversification benefits), increases volatility, cuts performance dramatically on any risk-adjusted measure and incurs serious transaction cost penalties.
There is virtually no degradation in performance nor incremental turnover costs when using a negative-based ESG screen (i.e., removing only companies that have an actively bad ESG score).
Negative screening improves the ESG scores of the factor portfolios by an amount similar to the more restrictive positive screening.
ESG-screened portfolios that use exclusion screening perform better than unscreened portfolios, but they also are more “growthy” — the loading on HML (the high BTM-low BTM value factor) was lower in the negative ESG-screened portfolio than in the unscreened portfolio. The unscreened portfolio had an HML score of 0.16, which was significant, versus the negative ESG-screened portfolio, which was 0.03 and not significant.
Profitable firms tend to have strong ESG characteristics.

Their findings led Cai, Cooper and He to conclude: “We have shown that ESG investing in a factor-based framework may be pursued without giving up return, risk, or transaction costs. However, the manner of implementation makes a difference. Specifically, we find that excluding companies with a combined ESG score below the industry mean is far superior to including only companies that are scored and have ESG scores at or greater than the industry mean. This is despite the fact that either method provides roughly equal improvement in the overall ESG score of the benchmark portfolio.” They added: “We find that our negative screening methodology hits a sweet spot for ESG investment. … However, actively screening for ESG-positive companies does come with significant costs.”

Cai, Cooper and He’s findings are consistent with those of Fabio Alessandrini and Eric Jondeau, who examined whether improving the ESG of a portfolio impacted performance, tracking error relative to a benchmark and the efficiency of factor-based strategies in their study ESG Investing: From Sin Stocks to Smart Beta, published in the 2020 Ethical Investing issue of The Journal of Portfolio Management. Alessandrini and Jondeau found that ESG exclusion does not lead to a reduction in risk-adjusted returns for factor-based strategies.

Investor takeaway

For investors, the takeaway is that if you are going to make ESG investing a core of your investment philosophy, thorough due diligence is required before committing assets. That due diligence should not only include the screening methodologies but also a careful examination of factor loadings, industry concentrations, country exposures and expenses.

For informational and educational purposes only and should not be construed as specific investment, accounting, legal, or tax advice. Certain information is based upon third party data which may become outdated or otherwise superseded without notice. Third party information is deemed to be reliable, however its accuracy and completeness cannot be guaranteed. By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party websites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them. The opinions expressed by featured authors are their own and may not accurately reflect those of the Buckingham Strategic Wealth® or Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. Neither the Securities and Exchange Commission (SEC) nor any other federal or state agency have approved, determined the accuracy, or confirmed the accuracy of this article. LSR-22-221

LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of numerous books on investing.

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