Desperately Seeking Alpha

Values-Aligned Investing
June 22, 2018

In April 2018, the US Department of Labor (DOL) issued new guidelines on environmental, social, and governance (ESG) issues as drivers of investment choices. The new guidelines differ from those issued in 2016, which said retirement plans could consider ESG without violating fiduciary duty. The investment industry has tended to read the new guidelines as a slap in the face to ESG investing. You might expect Aperio, as a player in the ESG space, to react negatively to the DOL’s new guidance, and we do oppose lessening the freedom to include ESG issues as a fiduciary. However, there may be more nuance to the DOL guidelines than meets the eye, and we’ll put on our consumer activist hat as we delve further into what’s going on across the ESG industry. For us, a pro-consumer perspective often means a healthy skepticism regarding any claim to predictions of pre-tax alpha from any strategy, whether from ESG, smart beta, or old-fashioned stock picking.

In the recent past, we’ve noticed a lot of strategies promoting ESG factors as a reliable way to outperform the market.1 While there’s no dispute that investor interest in ESG issues has expanded significantly,2 the idea that ESG factors lead to outperformance is far less certain than one might be led to believe from reading what is turning into a lot of hype. We see two different constituencies who greatly benefit from the narrative of alpha coming from ESG factors, and we’ll examine each using a framework from behavioral economics and psychology.

The first group that benefits includes some of the folks we’ll call the ESG advocates, which include the investors who care about ESG issues as well as those seeking change through corporate behavior. As recently as 10 years ago, much of the interest behind ESG investing originated in consumer preferences to incorporate environmental, social, or governance values in their portfolios. Investors can reflect their ESG preferences in public equities through at least four different methods: 1) negative screening, or the elimination of companies undesirable for whatever reason; 2) positive scoring, or the effort to own more of what are deemed the best corporate actors; 3) proxy voting, a more passive effort to change corporate responsibility; and 4) shareholder engagement, actively engaging in dialog with companies and sometimes proposing resolutions. For many ESG investors, these four techniques have furthered their goals (and still do), especially when the incremental comparative risk taken on so often can be forecast as fairly trivial.3

However, some ESG advocates have shifted emphasis to ESG factors not solely to reflect preferences but also for the promise of better performance or risk management, a line of thought that goes back to at least the 1990s. While at Aperio we do support additional disclosure as better for investor control of the assets they own, we part ways with the ESG advocates when we hear the certainty with which they can sometimes conflate ESG screening and expectations of positive alpha, or outperforming the market. We’re skeptical not because the pre-tax alpha comes from ESG factors but rather because we recommend skepticism across all forms of expected pre-tax alpha, including the strategies we offer to our clients through factor tilts as well as ESG strategies.

Here’s where we bring in behavioral economics and psychology. The human mind has evolved over time to yearn for justification of our most cherished beliefs, often described as confirmation bias in academic parlance. Social psychologist and New York University Stern School of Business professor Jonathan Haidt takes this idea even further, arguing that one can characterize the purpose of the rational mind as creating justification for what our emotional or subconscious mind wants. In his book The Happiness Hypothesis and other works, Haidt likens the rational mind’s role to that of a presidential press secretary, whose job to some extent is to justify the president’s actions. That role of justification plays out irrespective of the political leaning of a particular administration; i.e., both left- and right-wing administrations spin narrative. Looking at the hype about ESG alpha and the actual research, including some of our own, we see the longing for justification of belief systems dominating the actual level of confidence investors should feel. That doesn’t mean that ESG factors won’t prove to be valuable insights into stock performance—and in fact, we’d argue that good fundamental research about individual stocks has to include ESG factors. However, we consider it much more of a stretch to suggest that an active manager can outperform the stock market just because ESG factors may eventually be proven to explain performance of individual stocks. For active managers to successfully add pre-tax alpha through ESG, they don’t need to prove that ESG factors matter; instead, they need to prove that they’re better than the market as a whole at predicting how ESG factors will drive individual stock performance. In other words, we agree that ESG factors will become part of stock analysis, but we disagree that that means ESG strategies will outperform the market.

Now that we’re talking about active managers, we come to the second group that benefits from the ESG alpha hype. As anyone studying fund flows over the past few years is aware, active managers are on the ropes, under enormous pressure from indexing in all its guises and from relentless pressure on fees. To put it in colorful psychological terms, we see active managers looking at ESG factors as a white knight riding to the rescue of a beleaguered industry. Anyone who knows Aperio’s beliefs has heard us warn that it’s important to focus on the economic incentive of anyone giving out investment advice (which certainly should apply to us as well). We counsel investors listening to the active management side of the investment industry to pay heed to the objectivity (or lack thereof) around ESG factors. When we look at the hype around ESG alpha, we can see that it’s getting pretty crazy out there. Even as articles are published on the outperformance of certain ESG factors or strategies, keep in mind that one article in isolation does not a proven anomaly make. Analogously, even though we offer many factor strategies, we tend to be more open to those with a long history of research across many experts and many decades than a one-off finding. We still remember one of our first ESG clients who years ago suggested to us that three months of outperformance proved the superiority of the particular belief system they had implemented. Furthermore, while we’re skeptical of positive alpha derived from ESG, we’ve also published works arguing against the traditional dismissal of ESG as a sure way to create negative alpha.4

Let’s return now to the DOL guidelines and what they actually say: “It does not ineluctably follow from the fact that an investment promotes ESG factors...that the investment is a prudent choice for…investors.” We agree with that statement because we’d say that almost any pre-tax active strategy could be substituted for “ESG factors” in the DOL’s wording. At Aperio, we think that the prudent choice for investors is to focus on the things that can be controlled, starting with fees, taxes (if applicable), and to a lesser extent risk. We urge skepticism of promises of pre-tax outperformance, however much pleasure such prospects might provide inside our brains or the brains of those who get paid to pick stocks on our behalf.

Send questions or comments to

1 For research on the topic, see the following papers from MSCI: “Can ESG Add Alpha?” and “Foundations of ESG Investing.”
2 See “Global sustainable investments grow 25% to $23 trillion,” Bloomberg Briefs, July 24, 2017.
3 See Patrick Geddes, “Measuring the Risk Impact of Social Screening,” Journal of Investment Consulting, 13, no. 1 (2012): 45–53.
4 See ibid. and also Patrick Geddes, “Do the Investment Math: Building a Carbon-Free Portfolio.”

© 2021 BlackRock, Inc. All rights reserved.

This material is provided for informational purposes only and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are subject to change at any time without notice. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be and should not be interpreted as recommendations.

This material may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections, forecasts, estimates of yields or returns, and proposed or expected portfolio composition. Moreover, any historical performance information of other investment vehicles or composite accounts managed by BlackRock, Inc. and/or its subsidiaries (together, “BlackRock”) included in this material is presented by way of example only. No representation is made that any performance presented will be achieved, or that every assumption made in achieving, calculating or presenting either the forward-looking information or the historical performance information herein has been considered or stated in preparing this material. Any changes to assumptions that may have been made in preparing this material could have a material impact on the investment returns that are presented herein by way of example. Past performance is no guarantee of future results.

The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy.