Financial practitioners have lots of incentives to believe that environmental, social, and governance (ESG) investing delivers alpha. For example, ESG is among a limited number of growth areas in the financial services industry, and investors are naturally enticed by the idea that a portfolio can be both profitable and virtuous. Still, ESG alpha is hard to pin down, because it is a new concept with a short data history, because it is a grab bag of imprecise terms and disparate definitions, and because the pursuit of any kind of alpha is a high-stakes-low-probability affair.
To illustrate some of the difficulties in making careful and precise statements about ESG strategies, we looked at the performance of two popular ESG investments over the past two years. SHE, the SPDR® SSGA Gender Diversity Index ETF, underperformed the S&P 500, while PBW, the Invesco WilderHill Clean Energy ETF, outperformed. Does this mean that gender diversity has negative alpha and clean energy has positive alpha? Certainly not, since many other portfolios also attempt to represent those concepts.1 And extrapolating anything about the future from this short time period could be dangerous. SHE may continue to underperform or perhaps the negative performance of SHE will reverse over time, only to reward those with the patience and vision to stick with the investment.
Source: Bloomberg L.P.
Looking over a longer period of four years, we see that PBW has not always outperformed. An investor with the patience and vision to choose PBW four years ago and stick with it would have been rewarded with a cumulative alpha of negative 40%.
Source: Bloomberg L.P.
In a previous blog, my colleague Pete Hand enumerated five of the countless ways that an alpha strategy can go wrong. His framework reminds us of just how well specified an alpha strategy needs to be in order to create conditions where skill rather than luck drives investment results. The vague notion that profit will emerge from the alignment of either personal values or “material” issues with investment dollars is the antithesis of an orderly approach to alpha generation. An examination of the incentives of those who proclaim that this alignment will lead to outperformance should give alpha-seeking ESG investors reason to pause before signing on.
Our inclination to believe that we will be rewarded for doing the right thing is a heart-warming human attribute. Taking account of the concept’s short history, however, there can be no credible answer anytime soon to the question of whether ESG investing delivers alpha. And given the many different and sometimes disparate ideas that ESG alpha encompasses, we may never arrive at an answer.
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