The ESG story: Icarus or Cinderella?
‘From ancient myths and legends to modern Hollywood blockbusters, most of the stories we tell ourselves can fit into just a few narrative archetypes’. Do any of these narrative archetypes fit the great story of asset management today: the popularity of investing according to environmental, social, and governance (ESG) considerations?
Two possibilities stand out: Icarus (the classic ‘rise and fall’ tale) and Cinderella (rise, fall, rise). Both follow the same initial arc, but have vitally different endings.
In financial markets, the rise element is essentially a product of investor demand. Right now, investors in aggregate are demanding securities with high ESG scores. There are plenty of reasons for them to do so, from their own principles to expectations that highly rated ESG assets will outperform in the future (whether due to better governance, lower environmental risks, etc).
But what comes after the rise? In 1987, Robert Merton demonstrated that when a large group of investors ignores certain stocks – say, those with poor ESG profiles – those stocks can become undervalued. In general, these lower valuations ultimately imply higher expected returns relative to stocks with stronger ESG credentials.
You don’t even need to believe in mean reversion as an iron law to expect this. Even if the undervaluation of ESG laggards is permanent thanks to persistently high demand for superior ESG scores, a low stock price still implies a high dividend/price ratio, hence higher returns, ceteris paribus. And this is to say nothing of companies having incentives to improve their ESG ratings.
So over the longer term, presuming that ESG strategies become more mainstream and sustain demand for such assets, purely as a matter of financial theory it is possible to argue that any potential outperformance from ESG could dissipate for three primary reasons:
- First, the under-reaction to intangible ESG information would disappear as many investors pursue strategies based on such information. This is similar to any other strategy based on other investors neglecting value‐relevant information.
- Second, the popularity argument is based on growth in demand, and thus is temporary by nature – it will at best plateau.
- Third, the role of ‘ignored stocks’ is more relevant the larger the group of investors pursuing ESG strategies becomes. That is, the higher the flows into ESG strategies are, the larger the likely outperformance of the stocks they neglect becomes thanks to the risk premium that will have to be attached to them.
So far, so Icarus. But what could give ESG strategies their Cinderella ending? There are two pertinent questions for today’s responsible investors on this topic. First, how close are we to a steady‐state level of ESG allocations? Second, how important is the ‘ignored stocks’ argument for stock prices, and hence for future stock returns?
On the first question, we believe ESG strategies can continue to gain both absolute assets under management and relative market share for many years to come. The latest Investment Association numbers show that in the UK only £31 billion of the industry’s £1.2 trillion in funds under management is in ‘responsible investment’ mandates – a mere 2.5% of the total.
On the second question, we believe many of these ignored stocks – from fossil fuels to tobacco – may be classic value traps rather than value opportunities. Their share prices may be depressed by the weight of assets going into ESG strategies, but we believe their cash flows are also going to be permanently depressed over the long term as their business models become obsolete and/or customers shun their products and services in favour of more responsible competitors.
If they do not adjust appropriately to the transition to a lower-carbon economy or act on other issues around sustainability, in our view their valuations don’t have much hope of recovering to the market average, no matter how neglected they are by investors.
Responsible investors, then, may have a good chance of living happily ever after.