Spurious correlation explains ESG alpha, say experts

There is definite proof that sustainability-focused funds are outperforming their conventional counterparts. But some experts believe the traditional explanations for this are wrong.
Spurious correlation explains ESG alpha, say experts

The evidence is clear: ESG funds are outperforming their conventional counterparts. But some experts are questioning the traditional explanations for why that is.

Investing responsibly does not have to come at the expense of reduced returns. More and more data has shown this to be the case. As a result, the appetite for environmental, social and governance investing has shot up in recent months.

Morningstar found 75% of ESG-screened indices it studied outperformed their broad market equivalents in 2020. Similarly, 57 of 65, or 88%, outperformed for the five years through the end of 2020.

This may not be happening for the reasons that have been trotted out for many years now. Some critics argue that the link between ESG credentials and better returns is not clear-cut and indeed might run in the opposite direction.

Felix Goltz, Scientific Beta

“Is it that having good ESG practices helps companies improve profitability? Or is it just that companies with high profitability have the resources to also develop ESG policies?” said Felix Goltz, director at think-tank Scientific Beta, part of France’s EDHEC Business School.

Goltz has co-written a paper showing that quality factors such as profitability (gross profits divided by assets) and the conservative nature of investment can explain much of the purported ESG outperformance that occurs.  Adjust for these and no alpha, or abnormal returns, is gained from information on ESG ratings, the study shows.

His findings imply that investors would do just as well by investing in firms with high profitability who are disciplined about how they deploy capital.

Craig Cameron, manager of Franklin Templeton’s Global Climate Change Fund, reiterates Goltz’s assessment.

“Quality companies typically demonstrate better ESG credentials. This is because large, profitable companies like [US tech and data companies] Apple and Facebook have the financial resources to spend on ESG initiatives like offsetting their carbon footprint.”

This contrasts with, for example, the airline industry, he says, “where there is high competition, low margins, and which is going through a difficult time right now”.

Craig Cameron,
Franklin Templeton

Cameron has his own alternative explanation for why ESG funds might appear to be outperforming: “The vast majority of the companies [in these funds] I think were outperforming simply because there’s more money flowing into ESG products. And these funds were forced to buy a lot of companies at increasingly higher prices.

"So the strongest performers on an environmental basis are now typically trading at a much higher price to earnings multiple than they were 24 months ago.”

Indeed, Scientific Beta found patterns that back this theory. “We looked at investor flows as a measure of investor attention to ESG and found the outperformance in high attention periods is four times higher than in the low attention periods,” Goltz told AsianInvestor.


The Scientific Beta report also showed that many ESG strategies have noticeable biases towards tech, a sector that fared well in 2020.

BlackRock, the world's largest fund manager by assets, was criticised for the heavy concentration on technology stocks in its US Carbon Transition Readiness fund, which it launched in April 2021. Its largest holdings include technology leaders Apple, Microsoft, Amazon, Alphabet and Facebook. The fund raised $1.25 billion from institutional investors like California State Teachers’ Retirement System and Temasek, making it the largest ETF launch in history.

“Many asset managers are taking that approach [of including tech companies in ESG funds]. And I think that has started to muddy the waters or the link between what is actually ESG and what is just buying quality companies,” said Cameron.


Are investors also ignoring other variables, such as capital intensity, allowing a spurious correlation to be created between ESG and performance?

Alexander Treves,
JP Morgan AM

ESG credentials for the old economy, such as mining, oil exploration, utilities and other polluting industries, are generally inferior to those for the new economy, such as healthcare and retail, said Alexander Treves, emerging markets and Asia Pacific equities investment specialist at J.P. Morgan Asset Management. At the same time, you see better performance for the new economy compared to the old economy because the old tends to be more capital intensive, which is bad for long-run returns, he said.

In this example, the outperformance of new economy companies would appear to be down to their superiority in ESG, but may in fact be because of their lower capital intensity.

However, Treves is convinced  of the long-term benefit of good ESG practices in helping companies mitigate risk and deliver higher returns.


At best, fund managers want investors to take ESG seriously when making investment decisions. This coupled with a lack of understanding of cause and effect in this instance is leading to widespread claims of overperformance of ESG investments.

At worse, fund managers are deliberately greenwashing to drive up demand and charge higher management fees. Whlle BlackRock’s carbon readiness fund charges a fee of 30 basis points – above passive ESG ETFs in the US with a higher active share, other active ESG ETFs have a median fee of 45 basis points, notes Bloomberg Intelligence.

“I think in general, the industry – investors, consultants and anyone selecting investment products – should be more demanding with claims of outperformance,” said Goltz. “They should definitely scrutinise this more.”

Investors should also question whether investing into funds like BlackRock’s will have a positive impact on the environment. The companies that make up the fund, like Facebook and Apple, already have a low carbon footprint.

“Are you going to change the world by investing in Facebook? I'm not so sure,” Cameron said. “Small efforts by airline companies are actually going to make a much bigger difference than big efforts by a company like Facebook.”

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