When companies take positive environmental, social and governance (ESG) steps, they attract asset flows from fund managers, according to new research. But the price spikes from those flows may not result in outperformance for long-term investors.
With the dramatic growth in demand from investors for sustainable investing strategies, incorporating ESG information into investment decisions has become increasingly important for asset managers. For example, Samuel Hartzmark and Abigail Sussman, authors of the 2019 study, “Do Investors Value Sustainability? A Natural Experiment Examining Ranking and Fund Flows,” found that mutual fund investors collectively put a positive value on ESG and that funds with the highest ESG ratings attract more flows. Thus, to attract cash flows, fund managers will incorporate ESG information into their portfolios in a timely manner. In addition, it seems likely that doing so would be perceived by investors as an indicator of investment skill.
Linquan Chen, Yao Chen, Alok Kumar and Woon Sau Leung, authors of the December 2020 study “Firm-Level ESG News and Active Fund Management,” used the daily frequency Pulse scores constructed by Truvalue Labs (TVL, now part of FactSet) to quantify the impact of firm-specific ESG news on fund managers. The authors explained: “Every day, TVL’s artificial intelligence (AI) engine reads news articles, commentaries, and reports from over 100,000 creditable sources (e.g., media, stakeholders, non-governmental organizations, think tanks, and industry experts), and applies natural language processing to analyze the semantic tone in each article. These unstructured news data are then aggregated into continuous firm-level scores, which we use to define a firm-level ESG news index.” They then analyzed the quarterly reports of all actively managed equity mutual funds in the United States from 2007 to 2017 to determine the impact of ESG news on their holdings. Following is a summary of their findings:
- There is a significantly positive relation between firm-level ESG news index and mutual fund holdings – firms with positive ESG news attract higher aggregate mutual fund ownership.
- The 2016 introduction of Morningstar’s Sustainability Rating significantly raised investor awareness about sustainable investing – relative to bottom-rated funds, top-rated funds are more likely to act on ESG news after this event.
- Managers with higher propensity to trade on ESG news earned superior risk-adjusted returns – the annual four-factor alpha of managers with the highest propensity to trade on ESG news was higher than that of managers with the lowest propensity by 0.64%.
Their findings led the authors to conclude that “fund managers respond to new ESG information beyond the information contained in conventional ESG ratings.”
The finding of superior risk-adjusted returns for managers with the highest propensity to trade on ESG news should be viewed with caution because investor preferences lead to different short- and long-term impacts on asset prices and returns. Firms with high sustainable investing scores earn rising portfolio weights, leading to short-term capital gains for their stocks – realized returns rise temporarily. However, higher valuations reduce expected long-term returns. The result can be an increase in green-asset returns even though brown assets earn higher expected returns.
Summary
The authors’ findings demonstrate that investor demand for sustainable funds has led to changes in the behavior of fund managers catering to that demand. And that behavior is having profound impacts on companies: Those that adhere to positive ESG principles have lower costs of capital, higher valuations and are less vulnerable to systemic risks. That leads to companies taking actions to become more sustainable; otherwise, they will be at a competitive disadvantage due to their higher costs of capital. By expressing their social values, investors are having a direct impact by causing companies to be more sustainable.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
Important Disclosure: This information is for educational purposes only and should not be construed as specific investment, accounting, legal or tax advice. Certain information may be based on third party data which may become outdated or otherwise superseded. Third party data is deemed to be reliable, but its accuracy cannot be guaranteed. The opinions expressed by featured authors are their own and may not accurately reflect those of Buckingham Strategic Wealth® or Buckingham Strategic Partners®, collectively Buckingham Wealth Partners. LSR-21-21
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When companies take positive environmental, social and governance (ESG) steps, they attract asset flows from fund managers, according to new research. But the price spikes from those flows may not result in outperformance for long-term investors.
