Are ESG Ratings Misleading Investors? A Quantitative Analysis
Institutions Question the Reliability of ESG Ratings
Many institutions are growing skeptical of Environmental, Social, and Governance (ESG) ratings – and for good reason. Recent research has revealed that the inclusion of ESG metrics in portfolio construction can have unintended consequences.
A Quantitative Study on ESG Metrics
In a recent study, we collected data on the trading activity of stocks listed on major exchanges from 1998 to 2020, along with corresponding ESG data. We quantitatively analyzed the inclusion of ESG metrics in two ways.
- Strategy 1: We compared trading strategies that focused solely on returns with those that considered both returns and ESG scores. Surprisingly, strategies that disregarded ESG scores actually resulted in higher overall ESG scores compared to ESG-based rules.
- Strategy 2: We examined trading strategies that prioritized stocks with the highest overall ESG scores. However, this approach did not produce the most efficient portfolio in terms of risk-adjusted returns. While including ESG data led to higher returns, it also increased portfolio volatility.
The Pitfalls of ESG Metrics
Our findings may come as a surprise, but they highlight the inherent noise in ESG metrics. Including these metrics introduces estimation risk and can worsen portfolio allocation. In fact, explicitly targeting ESG metrics often results in portfolio allocations that are economically and environmentally worse than market allocations. This is consistent with prior research that shows significant disagreement among ESG ratings agencies, as their chosen metrics, measurement approaches, and weighting methods differ.
Moreover, recent studies have demonstrated that incorporating uncertainty associated with ESG metrics can lower financial returns.
The Complexity of ESG Measurement
Achieving broader impact through ESG investing is undoubtedly a noble goal, but the devil lies in the details. The selection and measurement of ESG metrics are of paramount importance, and the lack of clarity and consensus in this regard introduces significant noise into investors’ decision-making processes.
Understanding Public Perception of ESG Issues
To gain further insights, we conducted a survey of 1,500 individuals and asked them to rank 10 ESG topics. The results revealed that there is no statistically significant evidence to suggest that individuals believe companies should prioritize objectives other than maximizing shareholder value. However, among those who ranked climate change as a high priority, they acknowledged that it may not be a company’s primary objective. Some respondents even ranked company objectives around paying a living wage higher than their personal rankings of it. This suggests that people’s beliefs about companies doing more to address ESG issues are often a reflection of their own preferences.
The Impact of Information on ESG Support
In another experiment, we provided some respondents with information on the costs of renewable energy, while others received no additional information. We found that the group exposed to information had a lower level of support for renewable policies, highlighting the influence of information on attitudes toward ESG.
The Importance of a Balanced Approach
Our research emphasizes the need for a balanced approach to investing. While ESG metrics can offer valuable insights into a company’s broader societal impact, they should be viewed as a supplement rather than a replacement for traditional financial metrics. Investors must be cautious not to overly prioritize ESG at the expense of established, time-tested measures.
Christos A. Makridis, Ph.D., is the founder and CEO of Dainamic Banking and holds academic affiliations at Stanford University, among other institutions. Majeed Simaan, Ph.D., is a professor of finance and financial engineering at the School of Business at Stevens Institute of Technology.
