Research Affiliates: Term ESG strategy – A mischaracterization?


Research Affiliates: Term ESG strategy – A mischaracterization?

Ari Polychronopoulos

By Ari Polychronopoulos, Head of ESG at Research Affiliates
We believe the ‘term ESG strategy’ is a mischaracterization. It is the underlying investment process, not the ESG preferences reflected in a portfolio’s security selection, that drives performance. We view this trait as a benefit for investors.

An investment strategy represents a decision, or a set of decisions, that guide a portfolio’s risk-and-return profile over time. The underlying investment process drives the return of the chosen investment strategy, the modest exclusions and ESG preferences reflected in the securities selected for the portfolio do not. Consequently, we believe the term ESG strategy is generally a mischaracterization.

Whereas some managers use ESG measures to identify risks and opportunities, more often ESG metrics merely reflect investor preferences incorporated in an existing strategy. This distinction in no way disparages ESG investing. We view this trait as a benefit that affords us the ability to align our portfolios’ composition with our beliefs without having a meaningful impact on performance.

Making our case: preference, not strategy

For example, an investment strategy, such as an actively managed equity portfolio that favors companies with low valuations, strong financial health, and decent price momentum, when applied across various industries, sectors, and countries, will perform similarly relative to a market portfolio with or without incorporating ESG preferences.

If we select and size positions in a consistent manner, such a portfolio will tend to exhibit strong relative performance when companies that exhibit value, quality, and momentum characteristics perform well across exposures. The portfolio’s performance will follow the performance of its characteristics regardless of whether the opportunity set is small-cap retailers in the United States, renewable energy providers in Europe, or a global portfolio for which every publicly traded company is eligible.

We demonstrated the lack of impact ESG preferences have on performance by examining the five largest index-based ESG products (ETFs or mutual funds) by AUM currently available in the US market as of December 31st 2021. We would expect similar findings in other regions. The comparison of these five ESG investment vehicles to a non-ESG cap-weighted benchmark revealed essentially no differences – in top holdings, valuation metrics, and performance from May 2019 to December 2021 – among the portfolios, because the five products each weight their holdings by market capitalization. Thus, incorporating ESG metrics had virtually no impact on the portfolios.

Wary of growth-dominated cap-weighted ESG strategies?

Today, many investors may prefer an alternative to cap-weighted indices, especially when the valuation dispersion between cheap and expensive companies is as historically wide as it is today. Value stocks have merely become far cheaper than they normally are relative to growth stocks. The elevated discount for value stocks exists both within and outside the US market.

Across the US, developed ex US, and emerging markets, the valuation of value stocks relative to growth stocks is at historically high levels. Whereas value stocks are always cheaper than growth stocks, the degree to which value stocks are cheaper varies considerably over time. The median relative valuation of value stocks to growth stocks over the period July 1968 through September 2021 is roughly 30% when measured by an average of the following four ratios that measure a company’s fundamental value: price to sales, price to earnings, price to book value, and price to dividends.

As of September 30th 2021, the valuations for the value factor were 16% in the US, 18% in developed ex US, and 15% in emerging markets. Our research, which examines the subsequent five-year annualized excess return that a value strategy has generated relative to a growth strategy from each starting point in the analysis, shows that lower starting valuations translate to better performance for value strategies relative to growth strategies.

Align your ESG preferences with your preferred strategy

Today’s heavily discounted valuations for value stocks relative to growth stocks and the resultant expected excess return for value stocks make us particularly wary of the future performance of growth-dominated cap-weighted indices.

Fortunately, investors can apply ESG preferences to any investment strategy. ESG-minded investors who are concerned with growth stocks’ high valuations can simply opt for a non-cap-weighted ESG strategy.

Disclaimer: Please refer to our disclosures