Editor's note: This article first appeared in the Q4 2021 issue of Morningstar magazine. Click here to subscribe.
The topic of environmental, social, and governance investing seems to be as polarizing as modern-day politics. It evokes powerful emotions, making it challenging for the different factions to find middle ground, or to even hear one another at all.
At Morningstar, we are fundamentally data-driven analysts and researchers striving to provide unbiased analysis. One way we can analyze the many facets of ESG is through the lens of an emerging and rigorous theoretical asset-pricing framework that embraces classical finance as well as behavioral finance. As regular readers of this magazine know, we call this the popularity asset pricing model, or PAPM.
Generally, investors approach ESG from one of two perspectives: risk and return or values and impact. Both views are valid, and the PAPM allows for both. Importantly, they need not be mutually exclusive. An investor’s holistic perspective on ESG is improved by trying to understand the different views and their interactions.
Views on Risk and Return From what is known as a pecuniary, or financial, perspective, there is a wide range of disagreement around how ESG impacts risk and return.
ESG Outperforms Without Superior Skill This group of investors believes that ESG investments will lead to superior risk-adjusted returns, because ESG risks are systematically not being properly reflected in asset prices to the degree that it leads to exploitable levels of asset mispricing. With this view, superior investment skill is not necessary to exploit the mispricing. This is the view of ESG evangelists.
ESG Outperforms With Superior Skill This group believes that ESG investments can lead to superior risk-adjusted returns conditional on superior investment skill (perhaps aided by superior information) in assessing ESG. Supporting this belief is the thesis that the market is less efficient at pricing ESG risks. As with other forms of active management, one must have an informational advantage or be better at interpreting available information. This is the view of ESG advocates.
ESG Performance Neutral This group believes that ESG risks, like all risks, are competitively priced, and to the degree that there is some level of asset mispricing/market inefficiency, it is difficult to produce superior risk-adjusted returns. This is the view of ESG skeptics.
ESG Underperforms This group believes that ESG investments will lead to inferior risk-adjusted returns. It regards ESG endeavors as a waste of money and resources that do not improve expected cash flows. This is the view of ESG detractors. We should note that the track record and evidence around easily exploitable opportunities, as well as active management, do not bode well for the first two risk and return views. Nor do they bode well for the final view, as this would suggest one could simply short stocks with attractive ESG attributes. Millions of investors seek superior returns. Many attempt to exploit any and all informational advantages. This is a powerful force acting against easily exploitable mispricing opportunities.
Values and Impact Preferences Many investors have nonpecuniary values and impact preferences that they want reflected in their portfolios. Importantly, an investor can simultaneously have values and impact preferences as well as any of the pecuniary views.
In the PAPM, the growing number of values- and impact-oriented investors, in particular those with nonpecuniary preferences for desirable ESG characteristics, may end up having a pecuniary impact on risk and return.
From a basic supply/demand perspective, if the number of investors who want portfolios with ESG attributes has been increasing (relative to supply), this may have helped the recent performance of stocks with better ESG characteristics. In the future, to the degree that demand increases faster than supply, it is reasonable to assume that on average stocks with better ESG characteristics will outperform. At some point, the popularity of ESG investing will reach something akin to a new equilibrium, reflecting a new higher level of popularity for assets with attractive ESG attributes. At this point, if all else is equal, the investments with the strongest ESG characteristics will have relatively high prices, and therefore, investors should expect lower future returns.
What About the CAPM and MPT? All of this is at odds with the dominant textbook capital asset pricing model, the CAPM, in which (1) the only priced characteristic is systematic risk, (2) all investors agree upon the expected returns and risks of all assets, which (3) leads to an equilibrium where all investors hold a portion of their wealth in the market portfolio and a long or short position in cash. Clearly, none of this holds true in real life.
The PAPM extends the CAPM by simultaneously allowing for any of the diverse views on the pecuniary impact of ESG, along with any combination of nonpecuniary investor preferences. It also accounts for the effect that nonpecuniary values and impact investors might exert on expected returns.
We periodically see the mistaken claim that modern portfolio theory, or MPT, does not consider ESG risk. This claim probably stems from a misunderstanding of MPT. The core of MPT is Harry Markowitz’s mean-variance optimization model in which an efficient frontier is created based on an investor’s estimates (forward-looking) of expected returns, standard deviations, and correlations. In the 1950s, Markowitz didn’t have the term ESG, and he was not proscriptive on how to estimate these inputs, but clearly, investors should consider all information—including ESG. That said, MPT does not fully address the implications of ESG investing. It does not contemplate investor preferences, or tastes, in the form of values- or impact-based investing. Thus, practitioners seeking to use mean-variance optimization in the presence of ESG preferences are limited to ad hoc constraints and excluding investments from the opportunity set. A more complete portfolio construction theory would recognize that some investors derive utility from a personalized portfolio that reflects their values and desire for impact.
Where does this leave us? We have a wide range of disagreement from a pecuniary perspective regarding how ESG affects risk and return; a variety of nonpecuniary tastes; and many investors who have both—unique views on risk and return and unique preferences. Furthermore, tools such as mean-variance optimization only work for the pecuniary aspect of ESG and not for its nonpecuniary aspects.
Fama and French to the Rescue! In a relatively unknown academic paper, Gene Fama and Ken French identified both disagreement and tastes as the two missing ingredients from the textbook asset pricing model. However, the duo stopped short of developing an actual model. Fortuitously, we, along with Roger Ibbotson, have developed just such a model—a formal equilibrium asset-pricing model, the PAPM, that incorporates both disagreement and tastes.
The PAPM provides a rich asset-pricing theory that can incorporate many facets, views, and preferences regarding ESG. It allows for diverse opinions on how ESG will affect risk and return and a range of investor ESG preferences. It also goes beyond ESG to include any characteristic that the investor believes affects price or may prefer, such as liquidity or faith-based precepts.
Perhaps the most important ramification of the PAPM relates to portfolio construction. In the PAPM, portfolio construction is nearly the antithesis of CAPM portfolio construction in which all investors hold a portion of their wealth in the market portfolio. In the PAPM world, all investors arrive at a personalized portfolio based on the two ingredients identified by Fama and French: (1) capital market assumptions that reflect all risks, including ESG risks; and (2) their values- and impact-oriented preferences. The PAPM contains an actionable portfolio construction problem that explicitly incorporates the idea that different investors derive utility in different ways.
In summary, the discord and confusion around ESG is partially due to the two general approaches—risk and return; values and impact. This is complicated further by the vast spectrum of beliefs around how ESG affects risk and return. Neither MPT’s mean-variance optimization nor the CAPM provides a clear framework for a world filled with a variety of views and preferences. The PAPM provides a rich theoretical ESG framework that allows for all investors—the evangelist, the advocate, the skeptic, and the detractor. Each can have his or her own detailed preference for a variety of values.
Thomas M. Idzorek, CFA, is chief investment officer, retirement, at Morningstar Investment Management. Paul D. Kaplan, Ph.D., CFA, is director of research with Morningstar Canada. Both are members of the editorial board of Morningstar magazine.