Andrew Ang has found some evidence of climate alpha in the past, but argues it is not a persistent structural factor, such as value or momentum.
The question of whether environmental, social and governance (ESG) considerations enable investors to generate excess returns and harvest a greenium or whether it results in poorer returns is a complex one.
With the global economy transitioning away from fossil fuels towards more sustainable forms of energy generation, you would think companies aligned with the energy transition would be better placed to benefit from the changing market conditions.
NGS Super takes this point of view and in a recent interview with [i3] Insights, Michael Mi, Deputy Chief Investment Officer of the fund, explained the fund’s decision to tilt away from companies with higher stranded asset risk has resulted in outperformance.
But finance theory says companies with higher risks should produce better investment returns as investors demand compensation for the increased level of risk they take. This would favour the brownium argument.
There are a lot of reasons to view companies with lower carbon emissions, higher ESG characteristics, more sustainable climate-resilient types of assets as less risky companies and they probably have lower returns
Looking back in history, it is possible to find data that supports either argument.
Yet, Andrew Ang, Investment Researcher and former Head of Factor, Sustainable and Solutions at BlackRock, tends to lean towards the view that generally green firms with less risk should, over the long run, have lower returns.
“I think there are a lot of reasons to view companies with lower carbon emissions, higher ESG characteristics, more sustainable climate-resilient types of assets as less risky companies and they probably have lower returns,” Ang says in an interview with [i3] Insights.
“It’s the brown stocks – the more risky stocks – that really actually should have the higher returns.”
He says companies that score well on ESG metrics will be better future-proofed and, therefore, should attract more investor demand, leading to higher stock prices and lower returns.
“I think this point is very underappreciated by the whole industry. And I think most of the uninformed opinions would actually say the opposite, that it’s the greener companies or the more sustainable companies that would have the higher returns,” he says.
“Economic theory predicts the opposite. If you do skew your portfolio towards some sustainability or climate-resilient tilts, you should actually expect lower returns.”
Implications for the Quality Factor
Although Ang’s argument aligns with a theoretical finance perspective, it seems to be at odds with the existence of the quality factor, a factor often associated with companies that score well on ESG.
If high-quality companies operate more sustainable business models and have good management to ensure their long-term survival, then these should theoretically produce lower returns as they can be considered less risky over the long term.
But the existence of a quality factor suggests investing in such companies produces higher returns compared to the broader equity market.
This is where behavioural finance comes in, Ang says.
“Value, momentum, quality, minimum volatility, they all have to result from either a reward for bearing risk, some impediment in market structure or investment behavioural biases of market participants,” he says.
The academic theories behind quality are mainly on the behavioural side. People talk about earnings fixation, where they focus on top-line earnings numbers, and they don't really look at how those earnings are formed
“One economic rationale for the quality factor is from a behavioural story. The rationale story goes in the opposite direction because, all else being equal, you would think that if a company has more resilient earnings, it has earnings that are less affected by various shocks – say to geopolitical instability or trade policy, which is in the news almost every day now – you probably would view that company as less risky and, all else being equal, that company would have a lower return.”
Where behavioural aspects come into play is that some investors are narrowly focused on earnings figures and don’t consider the sustainability of these profit levels or how they are generated. This means they often overpay for stocks that had a one-off windfall.
“The academic theories behind quality are mainly on the behavioural side. People talk about earnings fixation, where they focus on top-line earnings numbers, and they don’t really look at how those earnings are formed,” Ang says.
“So are they from [growing] operations or is the earnings generated from transitory effects? Does it come from financial engineering or maybe it’s from one-off transactions? After all, every company tries to beat consensus earnings forecasts.
“The risk premium story would tend to push it in the opposite direction. But we have seen in historical data lots of evidence that high-quality companies tend to outperform.
“It tends to come from investor behavioural bias.”
ESG as a Factor
Ang is not a sceptic when it comes to ESG. In fact, he has co-written several papers on the search for climate alpha.
For example, in 2021 he published a paper, together with co-authors and former colleagues at BlackRock Joshua Kazdin, Katharina Schwaiger and Viktoria-Sophie Wendt, on looking for alpha signals in data on carbon intensity.
Ang and his co-authors looked at the top 30 per cent of companies with the lowest carbon intensity scores in the MSCI ACWI Index over the period January 2010 to December 2020 and assessed whether there was any outperformance there.
And yes, these companies did seem to do better.
They then further optimised this approach through a long–short portfolio that went long companies with low-carbon-emission intensities and short companies with high-carbon-emission intensities. This resulted in an alpha of 1.49 per cent per year.
But Ang says this alpha isn’t persistent.
“Like any alpha, it’s just hard. Alphas based on climate or sustainability data will tend to degrade and sometimes will even flip signs,” he says.
Alphas based on climate or sustainability data will tend to degrade and sometimes will even flip signs
“In certain measures of carbon and in certain periods, some alpha signals have used carbon measures to generate returns. But overall, just because a company has lower carbon emissions, I would not take that prima facie as a sign that it’s going to outperform.”
So can ESG be considered a factor? Ang is not convinced.
Unlike value, momentum or quality, there doesn’t seem to be a strong economic rationale for most ESG signals that justifies a premium, whether it is behavioural, an impediment in market structure or compensation for risk.
“I think the jury is still out on that. Economic theory would tell us the reverse: lower risk, lower returns. Everything tends to point in the opposite way,” Ang says.
To Divest or not to Divest
If ESG is not a factor and alpha generated from climate data is not consistent, then what implication does this have for running negative screens, where investors divest from companies that score poorly on ESG-related metrics?
Ang says that as a starting point investors need to assume that restricting their investment universe leads to lower returns.
“The more divestments you have, the more you constrain your investment opportunities, the worse your return will be over time. Divesting from the coal, oil, utilities or defence – often the most common industries that are screened out – can reduce your long-run return by upwards of one per cent,” he says.
“Sometimes you will have to do some constraints that are given by the types of liabilities you have or the types of clients you have. Again, if you do those, then you should note the cost of implementing those carbon constraints.”
Focus Should be on Alpha
Although Ang doesn’t think ESG is a factor and, therefore, it would be hard to run a purely systematic approach with the objective of producing alpha from climate data, he does believe some active managers are better at interpreting this data than others.
Delivering alpha is very hard, but not impossible.
But in recent years, the focus on alpha has given way to the politicisation of ESG, something Ang feels detracts from investors’ objectives.
“I speak from the United States, where there’s been some misunderstanding and some politicalisation of these concepts. I wish that everyone had just kept their focus on is there alpha or not in this?” he says.
“Does it actually increase or decrease returns? And if it increases the returns, then this is a very compelling reason why you should include it in your portfolios.
“I feel that as an industry we’ve kind of lost that focus on alpha. We’ve shifted to compliance, we’ve shifted in some cases to opposite sides of a political debate rather than concentrating on investing, and sometimes we’ve shifted to a mindset of this is something that we’re forced to do.
“We should re-centre the conversation on actually, you know, does [ESG] add value for our portfolios.”
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