ESGinvesting:aliteraturereview

SørenHvidkjærProfessorofFinance

September2017

ReportpreparedforDansif

Pleaseaddressanycorrespondencetosh.fi@cbs.dk.IthankLotteJensenandSørenLarsenfortheircommentandsuggestions.

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1 INTRODUCTION  2

1.1 TheoreticalconsiderationstoESGinvesting 31.1.1 ActiveownershipandtheinteractionbetweenESandG 5

1.2 TheempiricalliteratureonESGinvestingandthescopeofthereview 6

1.3 Somegeneralobservationsonthearticlesreviewed 8

2 DETAILED REVIEW OF INDIVIDUAL ARTICLES  9

2.1 Thesinstockevidence 10

2.2 EvidencebasedonESGratingsusingpositive/negativescreening 152.2.1 Environmentalscreens 172.2.2 Socialscreens 182.2.3 Governancescreens 19

2.3 StockmarketreactionstoESGevents 21

2.4 Activeownership 23

2.5 Metastudies 24

3 CONCLUSION AND DISCUSSION OF THE FINDINGS  25

REFERENCES  28

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1 Introduction AfundamentalquestiontoinvestingbasedonEnvironmental,SocialandGovernance(ESG)considerationsishowdoessuchinvestingaffectthevalueoftheinvestor’sportfolio?Thisreportreviewsthecurrentevidenceonthisquestion.Specifically,howdoesESGinformationaffecttherisk‐returncharacteristicsofaninvestor’sportfolio,hencetheformationoftheoptimalportfolio?1

ThefindingsofthereviewedempiricalstudiesofESGinvestingcanbesummarizedasfollows:

1. Considerableevidenceexiststhatso‐calledsinstocksexhibitoutperformancerelativetovariousbenchmarks.

2. ThereisevidencethatstockwithhighESGratingsexhibithighfuturereturns.Theevidenceisstrongestin1991‐2004,whilethereturnsofstockswithhighESGratingsdonotappeartodifferfrombenchmarksin2005‐2012.Someevidencesuggeststhatreturnsagainhavebeenhighsince2012.

a. Theevidenceoninvestorreturnstoenvironmentalscreensislimitedandtheresultsaremixed.

b. Investorreturnstoatleastonesocialscreen,namelyemployeesatisfaction,werehighduring1984‐2011.

c. GoodgovernancefirmsasmeasuredbytheG‐indexhadhigherreturnsthanpoorgovernancefirmsin1990‐1999.However,thereturndifferencedisappearedinthesubsequentperiod.Someevidencesuggeststhatothermeasuresofgovernancepredictreturnsinthesubsequentperiod,buttheevidenceisnotconclusive.

3. EventstudiesindicatethatthestockmarketdoesnotrespondpositivelytocertaintypesofESG/CSRinitiativestakenbyfirms.Whiletheresultssuggestthatagencyissuesareagenuineconcern,theyalsosuggestthatsuchconcernscanbemitigatedthroughsoundcorporategovernance.

4. ActiveownershipbyESGinvestorscancreatevalue,bothforshareholdersandotherstakeholders.

Toappreciatethesignificanceoftheaboveresults,itiscentralfirsttodevelopanunderstandingofthepossiblechannelsthroughwhichasignalcanimpactreturns.Withoutsuchanunderstanding,theinvestorwillhavenowayofdevelopinganinformedopinionofwhetherausefulsignalinthepastwillholdin

1ThereviewwillfocusnarrowlyontheeffectoffollowingESGstrategiesonportfoliovalue.Otheraspectsincludeethical,politicalandmarketingconsiderations.Whiletheseaspectsclearlycanbeimportantforaninvestor,theyareoutsidethescopeofthecurrentpaper.

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thefuture,orwhethernewsignalsarelikelytobecomerelevant.Therefore,thisreportwillbeginwithadiscussionofthetheoreticalaspectsofESGinvesting.ThereportthenprovidesabriefoverviewoftheempiricalliteratureonESGandthetypesofquestionsaddressed.Section2givesadetailedreviewofkeyarticlesinsin‐stockinvesting,positive/negativeESGscreening,eventstudies,activeownership,andmetastudies.Section3concludesandprovidessomeperspectivesontheconsequencesoftheresultsforinvestors.

1.1 Theoretical considerations to ESG investing 

PlausiblereasonsexistforbothoutperformanceandunderperformanceofESGinvestingrelativetoconventionalinvesting.Inthefollowing,wereviewtheargumentsastheypertaintoaninvestorwho(1)doesnotpossessinsideinformationaboutfirmvaluesand(2)doesnotengageinactiveownershipbydirectlyexertinginfluenceonmanagement.2Forsuchaninvestor,thecentralquestiontoESGinvestorsisnotwhetherESGinitiativesbyfirmscreatevalue,butwhetheranysuchvalueisproperlyrecognizedbythestockmarket.

Ingeneral,themainargumentforoutperformanceofbasedESG‐strategiesis,inessence,thatthestockmarketunderreactstoESGinformation.Thatis,thevalueeffectsofapositiveESGeventisnotsufficientlyrecognizedbythestockmarket,hencefirmswithsucheventstendtobeundervaluedandastrategyinvestinginthesefirmscanobtainabnormallyhighreturns.

Theunderreactionhypothesisisplausible,giventhatevidenceexistsofstockmarketunderreactioninvarioussituations.Inparticular,post‐earningsannouncementdrift(BallandBrown,1968;andBernardandThomas,1989)andmomentum(JegadeeshandTitman,1993)arebothamongthemostrobustevidenceagainstmarketefficiencyandareconsistentwithmarketunderreaction.Moreover,areasonablehypothesisisthatthestockmarketundervaluescertainintangibles.Thevaluationofintangiblesistypicallymoreuncertainthantangiblesandoftenintangiblesdonotappeardirectlyonthebalancesheet,hencetheyarelesssalienttoinvestors.EvidenceofunderreactiontointangiblesincludesR&Dcosts,patentcitations,advertising,andsoftwaredevelopmentcosts(seereferencesp.622inEdmans,2011).Likewise,ESGinvestmentsbyfirmsaretypicallyintangibles,anditispossiblethatthestockmarketunderreacttotheinformationinESG‐relatedinitiatives.

AsecondreasonforwhyhighESGstocksmightoutperformthemarket(andlowESGstocks)isthatESGinvestinghasbecomemorepopularovertimewithinvestors.Thatis,agrowingdemandforaparticularsetofstockscanpushup

2Section1.1.1discussestheconsiderationstoactiveownership.

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thepricesofthosestocks,evenintheabsenceofnewfundamentalinformationaboutthevalueofthosestocks.

DemandeffectsarealsoaprimaryreasonforwhyhighESGstocksmightexhibitunderperformancerelativetolowESGstocks.Merton(1987)pointsoutthatwhenalargegroupofinvestorsignorecertainstocks,saylowESGstocks,theycanbecomeundervalued.Whilethisimpliesinitiallowreturns,subsequentlythosestockswillhavehighreturnsrelativetohighESGstocks.Eveniftheundervaluationispermanent,thenalowstockpriceimpliesahighdividend/priceratio,hencehigherreturns,ceterisparibus.3

Also,firmsinindustriesoftenshunnedbyESGinvestors,suchastobaccoandweaponsindustries,haveincentivestopracticeveryconservativeaccountingbecausetheirindustriesfallunderconsiderablescrutinyfromregulators(Berman,2002;HongandKaperczyk,2009).Totheextentthatinvestorsdonotaccountforthis,itwillleadtounderreactionandhencesubsequenthighreturns.

Theargumentforpricingeffectsoftheignoredstockdoesnottakefirms’responseintoaccount.LowESGfirmsmayrespondtofallinginvestorinterest,andthuslowerstockprice,bychangingbehavior.Heinkel,KrausandZechner(2001)analyzesuchasituationinatheoreticalmodel.Iffirmscanobtainalowercost‐of‐capitalbyattractingmoreESG‐consciousinvestorsbychangingtheirbehavior,thentheeffectonthecost‐of‐capital,henceonexpectedreturns,isalleviated.Suchactionscouldincludemakingmoreenvironmentallyfriendlyinvestmentsorimprovingemployees’workingconditions.

Almostperfectlyelasticdemandcurveswillleadtonounder‐oroverperformanceofhighESGstocks.ESGinvestingmightnotbesufficientlywidespreadtoaffectprices.Alternatively,arbitrageurscouldoffsetanyeffectofESGinvestorsbytradingintheoppositedirection.Still,withcostlyarbitragewewouldnotexpectanysuchfullyoffsettingeffect,asarbitrageursneedtobecompensatedfortheirefforts(GrossmanandStiglitz,1980).

However,ifevenESGinvestinghasnoimpactonprices,theindividualinvestormightstillexperiencenegativefinancialeffectsofESGinvestingfortworeasons.First,acentraltenetoffinanceisthatdiversificationprovidesriskreductionwithoutareductioninexpectedreturns(Markowitz,1959).Thus,investmentinabroadportfolioofassetsprovidestheoptimalrisk‐returntrade‐off,andanyrestrictionintheinvestableuniverseleadstoaworsetrade‐off.Intheabsenceofanypricingeffects,onewouldexpectsuchlack‐of‐diversificationeffectswouldbelargestifeitherentireindustriesareexcluded(asopposedtoexcludingtheworstESGperformerswithinanindustry).3AreinforcingeffectcomesfromthebreakdownofCAPMinsegmentedmarkets,hencethepriceofignoredstockscanbefurtherdepressediftheyhavehighidiosyncraticvolatility.

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Secondly,lowreturnstoESGinvestingintheabsenceofpriceeffectsmightoccuriftherearehighcoststoESGscreening.Thisisanespeciallypertinentchallengeforpassive,low‐costinvestors.Becauseofthediversificationargumentalongwiththeexistenceofnearlyinformationallyefficientmarket,animportantlessonfromfinanceisthatmostinvestorsshouldpursueapassive,low‐coststrategy.Thisentailsobtainingthecheapestpossibleexposuretoanassetclass,butESGrequirementscanbeincompatiblewithsuchagoalbecauseitinvolvesselectingindividualstocks.

Inlongerrun,assumingthatESGinvestingwillreachahighpermanentlevelofpenetrationamonginvestors,itisdifficulttoseehowanyoutperformancecouldbesustained,forthreereasons.First,theunderreactiontointangibleESGinformationwoulddisappearasmanyinvestorspursuestrategiesbasedonsuchinformation.Thisissimilartoanyotherstrategybasedonotherinvestorsneglectingvalue‐relevantinformation.Secondly,thepopularityargumentisbasedongrowthindemand,thustemporarybynature.Thirdly,theMertonargumentofignoredstocksbecomemorerelevant,thelargerthegroupofinvestorsis,whopursueESGstrategies.Thatis,thehigherthelevelofESGstrategiesamonginvestors,thelargeristhelikelyunderperformance.

Thus,therearetwopertinentquestionsfortoday’sESGinvestors.First,howclosearewetoasteady‐statelevelofESGinvesting?Secondly,howimportantistheMertonargumentforstockprices,henceforfuturestockreturns?

1.1.1 Active ownership and the interaction between ES and G 

Theabovediscussionassumesthatinvestorsareactiveinvestors,butpassiveowners.Bycontrast,activeowners(alsocalledactivistinvestors)directlyengagewithmanagementtochangedecisionsregarding,say,mattersrelatedtoESG.Suchactivitiesallowfordirectlyimpactingfirmvalueratherthanseekingtoidentifyundervaluedfirms.Onepossiblechannelforvaluecreationisalleviatingmanagerialmyopia.Thatis,principal‐agentissuessuchasmanagerialcareerconcernsmightleadmanagerstobecomefocusedonshort‐termresultsattheexpenseoflong‐termvaluecreation.Activeengagementbyinvestorscouldthusallowmanagementtotakealong‐termperspective.

ESGinvestingislinkedtoCorporateSocialResponsibility(CSR),whichinturnislinkedtothedebateofshareholdervaluevs.stakeholderwelfare.Often,stakeholdermanagementisfullyconsistentwiththeshareholdercriterion.AsJensen(2001),aprominentcriticofCSR,notes“wecannotmaximizethelong‐termmarketvalueofanorganizationifweignoreormistreatanyimportantconstituency(stakeholder)”.However,thereareclearprincipal‐agentproblemsinCSR,asthemanagermayengageinCSRforpersonalbenefitordrivenbysocialpreferencesratherthanmaximizingshareholdervalue.AsTirole(2001)

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notes,“managementcanalmostalwaysrationalizeanyactionbyinvokingitsimpactonthewelfareofsomestakeholder.Anempirebuildercanjustifyacostlyacquisitionbyaclaimthatthepurchasewillsaveacoupleofjobsintheacquiredfirm;amanagercanchoosehisbrother‐in‐lawassupplieronthegroundsthatthelatter’sproductionprocessisenvironmentallyfriendly”.4SuchproblemsindicatethatgoodcorporategovernanceisessentialinaligningCSRwithmaximizationofshareholdervalue.

Inshort,principal‐agentissuescancausemanagersexhibitmyopia,thusnotinvestinginvalue‐creatingESGinitiatives.Ontheotherhand,principal‐agentissuescanalsoleadtovalue‐destroyingESGinvestments.Therefore,GinvestingandactiveownershipensuringgoodcorporategovernancearguablyformsthebasisofsuccessfulESinvesting.

1.2 The empirical literature on ESG investing and the scope of the review 

TheliteratureESGinvestingispartofabroaderliteratureonhowCorporateSocialResponsibilityrelatestoCorporateFinancialPerformance.Thisliteraturecanbesplitinto4categories,accordingtothemethodologyappliedandquestionsaddressed.

First,isthequestionofwhetherinvestorscanformportfoliosbasedonESGsignalsthatcontaininformationaffectingtherisk‐returncharacteristicsoftheirportfolio,hencetheformationoftheoptimalportfolio.Thestandardprocedureisthustoidentifyasignal,sayanESGrating,andthenconstructaportfoliobasedonthesignalinordertoback‐testwhetheritcontainsvaluableinformation.Mostofthearticlesreviewedinthecurrentpaperusethisapproach,asitisthemostdirecttestoftherelevanceofESGissuestothevaluesofinvestors’portfolios.

Insteadofformingportfoliosbasedonindividualstocks,someresearchersstudytheperformanceofSRImutualfundsrelativetoconventionalfunds(orotherbenchmarks).Aconfoundingfactorhereisthatmanagementfeesaffectresults.Suchfeescanbebothdirectandindirect;henceitcanbedifficulttolinktheresultstotheunderlyingstockreturns.Relatedly,portfoliomanagerskillsdifferwhichinturnnecessitatesmakingassumptionsaboutthedistributionofskills.Further,theperformance‐flowrelationshipmakesithardtoestablishsystematicdifferencesinperformanceovertime.5Proponentsofstudiesincludingmutualfundsarguethatsuchportfoliosrepresentinvestableportfolioswhereasonemightinpracticenotbeabletoimplementstudiesusingindividualstockportfolios.However,thisisnotaninherentflawofstudiesbasedonindividual

4ThequotesfromJensenandTirolearealsoreproducedinRenneboog,HorstandZhang(2008),whichcontainsagoodreviewoftheearlyliteratureonCSR/SRI/ESGinvesting.5Thatis,successfulfundstendtoreceiveadditionalmoneyfrominvestors,butsuchadditionalmoneyisoftenhardertoinvestatsimilarlyhighexpectedreturns.

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stockreturns.Rather,theresearchercancontrolinvestabilityviatheweightingschemeoftheportfolios.

AsecondstrandoftheliteratureuseseventstudymethodologytostudythestockmarketresponsetoESG‐relatednews.ThisaddresseshowthestockmarketperceivesthevalueofspecificESGinitiatives;saythevoluntaryreductionintheemissionofgreenhousegasses.Theevidencefromeventstudiesarereviewedinsection2.3alongwithadiscussionofadvantagesanddrawbacksofsuchstudies.

AthirdstrandstudiestherelationshipbetweenCSR/ESGandaccounting‐basedperformancemeasures,suchasROAandROE.Here,aresearchermightfindthathighCSRfirmsaremoreprofitableandconcludethatCSRinitiativescreatevalueforshareholders.However,itisnotoriouslydifficulttoinfercausalityfromcorrelationsbetweendifferentcorporatevariables.Indeed,asRobertsandWhited(2013)note,“arguably,themostimportantandpervasiveissueconfrontingstudiesinempiricalcorporatefinanceisendogeneity”.AfirmwithahighESGscoremighthavehighprofitability,butthehighprofitabilitymightbedrivingtheabilitytoinvestinESGratherthantheESGinvestmentscausinghighprofitability.Toavoidsuchissuesofreversecausality,oneneedstoidentifyexogenousvariationintheESGvariable,ratherthansimplyshowingacorrelationbetweenthetwovariables.However,thecausalityissueisusuallynotproperlyaddressedintheCSRliterature.6

Moreover,findingthatsoundESGdecisionsaresoundbusinessdecisionsdoesnotimplythatinvestorsobtainsuperiorreturnsfrominvestinginthesefirms.Thecaseforinvestorsdependsonwhethertheinformationisalreadypricedintothestock.OnlyifthestockmarketsystematicallyundervaluessuchinformationwilltheESGinvestorobtainhighreturns.

Becauseofthedifficultyofestablishingcausalityandthelackofdirectimplicationsforinvestors,thisreviewwillnotcoverstudieslinkingCSRandaccountingperformance.

Afourthstrandoftheliteratureattemptstoobtainexantemeasuresoffirms’costofequitycapital.Absentfrictions,equityinvestors’requiredreturnsareequaltothefirms’costofequitycapital,thuspastaveragereturnsareexpostmeasuresoffirms’costofcapital.Exantemeasures,bycontrast,areusuallycomputedfromanalysts’earningsestimates.Theevidenceindicatesthathigh6AnexceptionisFlammer(2014)whousesaregressiondiscontinuitydesigntoshowthatnarrowlypassedCSRshareholderproposalsleadstopositiveaccountingperformance.Bycontrast,Hong,KubikandScheinkman(2012)identifyexogenousvariationinfinancialconstraintstoshowthatlessfinanciallyconstrainedfirmsengageinmoreCSR.Thus,theevidencesuggeststhatcausalitycanruninbothdirections,butmoreresearchisneededbeforemakingfirmerconclusions.

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ESGfirmsobtainalowercostofcapital(see,e.g.,Chava,2014),suggestingthatinvestorsarewillingtoacceptlowerreturnswheninvestinginhighESGfirms.However,aswithaccountingmeasures,exantecostofcapitaldonotdirectlymeasureinvestorreturns,hencethisreviewwillnotfocusonthesestudies.

1.3 Some general observations on the articles reviewed 

Afewgeneralobservationscanbemadeofthestudiesinthisreviewrelativetomostotherempiricalassetpricingstudies.

Manystudiesbaseinferencesonaveryshorttimeperiodduringwhichreturnsaremeasured.Severalstudiesemploytimespansoflessthan10years.Thisleadstoatleasttwopotentiallysevereproblems.First,generallytheassetpricingtestswillhavelowstatisticalpower.Testpoweristheprobabilitythatthetestcorrectlyrejectsthenullhypothesiswhenthealternativehypothesisistrue.Inthecurrentcontext,thenullhypothesisisthatthereisnodifferenceinaveragereturnsbetweentwosetsofstocks,sayhighESGandlowESGstocks,whilethealternativehypothesisisthatareturndifferenceexists.Therefore,thelowpowerbecomesanissuewhenresearchersarenotabletorejectthenullofnoreturndifferences.Theappropriateconclusionisthensimplythatonecannotrejectthenull.However,someresearchersappeartoconfuseabsenceofevidencewithevidenceofabsence.Thatis,evenifaveragereturndifferencesof3‐4%peryeararereported,someauthorsclaimthatnodifferencesexistratherthantheywerenotabletorejectthenullofnodifferences.

Thesecondchallengewhenusingshorttimespansisthatresultsbecomesensitivetoparticulardevelopmentsduringtheperiod.Forinstance,oilpricesmighthaveexhibitedaparticulartrendupordown,ortheeconomymighthavebeeninanexpansionarystageduringtheentiresampleperiod.Statisticaltechniquesarenotnecessarilyabletofullyaccountforsuchrealizationsofunderlyingfactors.

Thequestionofdifferencesinreturnsbetweentwosetsofstocksusesmethodologydevelopedwithintheresearchareaoffinance.However,manyofthearticlesdiscussedbelowarepublishedinjournalswithotherwiselittlefinancecontent.Whilemanyofthearticlespublishedinnon‐financejournalsappeartobemethodologicallysound,acoupleofdifferencesexistrelativetoarticlespublishedingoodfinancejournals.First,theeconometricmethodsemployedareusuallystandard,butmoresophisticatedmethodsarerarelyemployed.Forinstance,thestandardmethodincontrollingforanysizeandbook‐to‐marketeffectsisperformingFamaandFrench(1993)3‐factorregressions.However,usingcharacteristic‐adjustedreturnsasinEdmans(2011)allowsforinteractioneffectsthatwouldnotbecapturedby3‐factorregressions,butthismethodhasnotbeenappliedinarticlesinnon‐financejournals.Also,the

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applicationofthemethodslacksrigorinsomeinstances.Secondly,somearticlesaresimplynotwritteninaneutral,objectivelanguage.Onehopesthatthisdoesnotreflectalackofobjectivityintheanalysis.

Tobeclear,themajorityofstudiesapplysoundmethods.However,becausesomestudiesdoappeartoexhibitbiases,athoroughreadingandindependentinterpretationoftheresultshasbeennecessary,ratherthanrelyingontheauthors’presentation.

2 Detailed review of individual articles Inthissection,wewillfirstreviewtheliteratureonsinstockreturnstoevaluatetheeffectofsectorexclusionofESGinvesting.Then,weexaminetheevidenceofusingESGratingswithnegativeandpositivescreening.TheeffectsofgeneralESGscreeningisfirstexamined,andresultsforE,SandGareexaminedinturn.Insection2.3,studiesonstockmarketreactionstoESGeventsarereviewed.Section2.4discussedtheresultsfromarecentstudyofthefinancialeffectsofactiveownership.Finally,insection2.5wediscussarecentmetastudy.

Whilethearticlereviewsarebasedoncarefulreadings,thereisalsoavalueforthereaderinrecognizingthequalityofthepublishingjournal,asawidedispersionexistsinthequalityofacademicjournals.Articlesinhigherrankingjournalsareusuallyofahigherquality,inpartbecauseoftherigorousrefereeprocessandinpartbecauseofthesocialconstructionaspect(theyareperceivedashighquality,thusmoredesirableoutletsforauthors).Withinfinance,theundisputedtopjournalsaretheJournalofFinance,theReviewofFinancialStudiesandtheJournalofFinancialEconomics.Whileinferencesbasedonresultsinthesejournalstendtohavehighervaliditythanthosefromlowerrankingjournals,articlesinlower‐tierjournalsmaysimplyaddressmorenarrowquestions.

TheAssociationofBusinessSchool’srankingofjournalsisusedasaroughindicationofjournalquality.Table2.1replicatestheratingsexplanationfromtheABSAcademicJournalGuide2015.Inshort,4*journalsaretheleadingjournalswhile1‐ratedjournalsareofthelowestperceivedqualityamongratedjournals.Hence,theABSratingofeacharticleisnotedbelow.Sincenotallacademicjournalsarerated,non‐ratedjournalswillbeindicatedby“ABS0”below.ABS0journalsaretypicallyofalowerstandardthanABS1journals.

Moreover,journalsareratedwithintheirparticularfieldofstudy,butarticlesmayspandifferentfields.ThisisparticularlytrueforstudiesonEGSinvesting.Thisreviewerfindsthatthefinanceaspectsofthestudiestendtobeofhigherqualitywhenpublishedinfinancejournals.Therefore,allcitationsalsoindicatewhetherthearticleispublishedinafinance(F),non‐finance(NF)orpartlyfinance(F/NF)journal.

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Thefirstreferencetoeacharticlewillthusbeoftheformatauthornames(yearpublished,abbreviatedjournaltitle,ABSranking,ForNF).

Rating MeaningofQualityRating

4*

JournalsofDistinction.Withinthebusinessandmanagementfieldincludingeconomics,thereareasmallnumberofgrade4journalsthatarerecognisedworld‐wideasexemplarsofexcellence.Theirhighstatusisacknowledgedbytheirinclusioninanumberofwell‐regardedinternationaljournalqualitylists.TheGuidenormallyratesajournal4*iftheyareratedinthehighestcategorybyatleastthreeoutofthefivenon‐universitybasedlistings–FinancialTimes45,DallasList,VHB,AustralianDeans’List,CNRS.Inaddition,journalsfromcoresocialsciencesdisciplinesthatdonotappearinthoselistingsmayalsoberated4*onthegroundsthattheyareclearlyofthefinestqualityandofundisputedrelevancetobusinessandmanagement.IntheGuideof2015,thisappliestothreejournalsfromthefieldsofsociologyandpsychology.

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Alljournalsrated4,whetherincludedintheJournalofDistinctioncategoryornot,publishthemostoriginalandbest‐executedresearch.Astopjournalsintheirfield,thesejournalstypicallyhavehighsubmissionandlowacceptancerates.Papersareheavilyrefereed.Topjournalsgenerallyhavethehighestcitationimpactfactorswithintheirfield.

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3ratedjournalspublishoriginalandwellexecutedresearchpapersandarehighlyregarded.Thesejournalstypicallyhavegoodsubmissionratesandareveryselectiveinwhattheypublish.Papersareheavilyrefereed.Highlyregardedjournalsgenerallyhavegoodtoexcellentjournalmetricsrelativetoothersintheirfield,althoughatpresentnotalljournalsinthiscategorycarryacitationimpactfactor.

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Journalsinthiscategorypublishoriginalresearchofanacceptablestandard.Awellregardedjournalinitsfield,papersarefullyrefereedaccordingtoacceptedstandardsandconventions.Citationimpactfactorsaresomewhatmoremodestincertaincases.Manyexcellentpractitioner‐orientedarticlesarepublishedin2‐ratedjournals.

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Thesejournals,ingeneral,publishresearchofarecognised,butmoremodeststandardintheirfield.Papersareinmanyinstancesrefereedrelativelylightlyaccordingtoacceptedconventions.Fewjournalsinthiscategorycarryacitationimpactfactor.

Table2.1Source:ABSAcademicJournalGuide2015

Thereviewwillgenerallyfocusonarticlespublishedwithinthelastdecade.Earlierworkmighthavemademorefundamentalcontributions,butlaterworkbuildingonsuchcontributionswillusuallyincludetheoriginalsample,thuscontaintheinformationinearlywork.

2.1 The sin stock evidence 

Considerableevidenceexiststhatso‐calledsinstocksexhibitoutperformancerelativetovariousbenchmarks.

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HongandKacperczyk(2009,JFE,ABS4*F)isarguablythemostprominentandmost‐citedarticleonthereturneffectsofnegativescreening.AnalyzingU.S.stocks,theyfindthattheso‐calledsinstocks(definedinthepaperastobacco,alcoholandgamblingfirms)areheldbyrelativelyfewinstitutionalinvestorsandfollowedlessbyfinancialanalystsrelativetoacontrolgroupofstocks.Thisisconsistentwiththeclientelehypothesisthatsocialnormsleadsomeinvestorstoshunthesinstocks.UsingtheMerton(1987)argumentsthatstocksneglectedbyalargesegmentofinvestorswilltendtohavedepressedprices,hencehigherfuturereturns,HKinvestigatethereturnsofsinstocks.Theyfindthatsinstocksoutperformcomparableby3‐4%peryear.

Oneofthekeystrengthsofthearticleisthatthesamplecoversalongtimespan,namely1926‐2006(althoughthesampleperiodisshorterforinstitutionalownershipandanalystcoverage).ThisallowsformorepowerfulteststhanusuallyemployedintheESGliterature.Still,theresultsdonotappeartobeveryrobust.Forinstance,theinstitutionalownershipandanalystcoverageresultsarenotrobusttoinclusionofthemarket‐to‐bookratioasacontrolvariable(tables3Aand3C).ThereturntestsarestandardFama‐French(1993)factorregressions,andwhilealphasaresignificantinallspecifications(1,2,3and4factors),itisonlysignificantatthe10%levelinthestandard3‐factormodelinthe1965‐2006period(table4A).7Moreover,theexcessreturnsaredefinedrelativetothereturnsofaCOMPportfolioconsistingofcomparablestocksthatbelongtotheFamaandFrench(1997)industrygroups2(food),3(soda),7(fun),and43(mealsandhotels).Therefore,theinterpretationoftheresultsisthatsinstocksoutperformaportfoliooffood,soda,funand,mealsandhotelstocks.Thisisreasonable,butonemightalsoaskwhetheralphasaresignificantwhenexcessreturnsovertherisk‐freerateoragroupofcharacteristics‐matchedstocksareused(see,e.g.,Edmans,table3,2011).TheFama‐MacBethregressionsintable4Bindicatethatresultsareonlysignificantwhenaddingthecontrolgroup.

HKareheavilycritizedbyHoepnerandZeume(2013)andAdamssonandHoepner(2015).AHnoteonp.4that“HKregressanequal‐weightedportfolioofsinstocksonavalue‐weightedmarketbenchmark.Thisimpliesthattheoutperformancecouldbedrivenbyasmallcapperformancebiasratherthansinstockscharacteristics[…].Thisargumentisfoundedontheempiricalobservationthatsmallstocksoutperformlargestocks[…].Theexceptionallygoodperformancecouldhencebeduetoanover‐weightingofsmallcapstocksandunderweightingof

7TheFama‐Frenchmodelisthemostwidelyusedassetpricingmodelforprovidingbenchmarkreturnsinempiricalstudies.The3‐factormodelcontrolsforreturnsdrivenbyexposuretothemarketfactor,afirm‐sizefactorandabook‐to‐marketfactor.The4‐factormodelalsoincludesmomentum.Alphaisthepartoftheaveragereturnthatisnotexplainedbytheassetpricingmodel;hencealphaistheabnormalreturn.

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largecapstocks.”Thisargument,however,neglectsthefactthatHKuselong‐shortportfolios;henceanybiastowardssmallstocksislikelynettedoutbytheshortside.Indeed,theSIN‐COMPportfolioinHKloadsnegativelyonSMBinallspecificationsintable4A.ThisindicatesthatthestocksintheSINportfolioarelargerthanthoseoftheCOMPportfoliowhichisoppositeoftheAHclaim.

Thisisnottoimplythatthatequal‐vs.value‐weightingdoesnotmatter,butratherthatwhiletheeffectmightbegreateramongsmallstocksthanamonglargestocks,itisnotamanifestationofthesmallstockpremium.

Finally,AHclaimthattheHKsinresultsdisappearwhenusingvalue‐weightedreturns.However,AHuseamuchshortersample,namely2002‐2013.Itisclosetomeaninglesstousea12‐yearsampletomakesuchinferences.IfonewishestoarguethattheHKresultsdisappearwhenvalue‐weighting,onemustusethesamesampleasHK.

Fabozzi,MaandOliphant(2008,JPM,ABS2F)showthatsinstockexhibithighreturnsduring1970‐2007inseveralinternationalmarkets.Theyanalyzethereturnsof267stocksinalcohol,tobacco,biotech,defense,andadultentertainment(table2)in21countries.Theresultsarebasedonaone‐factormodelinwhicheachstockreturnisadjustedbythecorrespondingnationalindex,andtheportfolioreturnistheequallyweightedexcessreturns.Thereturnsarehighlysignificantbothforthecompositesinportfolio(table3)andforeachofthe6industryportfolios(table4).Thesinreturnsarealsoeconomicallysignificantwithroughly1%permonthmorethanthemarketreturn.Whileresultsarerobustwithrespecttothedefinitionofsin,wedonotknowtherobustnesswithrespecttovalue‐weightingortoalternativeassetpricingmodels.Still,giventheveryhighabnormalreturns,itdoesnotseemlikelythatastandardassetpricingmodel,suchastheFama‐Frenchmodel,wouldexplainthehighreturns.

TrinksandScholtens(2017,JBusEth,ABS3NF)showthatsinstockexhibithighreturnsduring1991‐2012inseveralinternationalmarkets.Theyselectattheindividualstocklevel(ratherthanexcludingindustries)andemployabroaddefinitionofsinwith14differentissues,includingmeatandcontraceptives.Thesampleislarge,consistingof1,634stocksacross94countries.

Tables3and4showstrongoutperformance:thevalue‐weightedTotalSinportfoliooutperformstheglobalFF‐4factorbenchmarkby91‐104bp.permonth–significantatthe1%level.Amongtheindividualsinissues,tobaccohasthestrongestabnormalreturnsof166bp.permonth.

Whiletheseresultsappeartobeverystrong,theyalsoindicatethattheglobalFF‐4factormodeldoesnotprovideareasonablebenchmark.Intable3,results

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arereportedforthezero‐investmentportfolioofTotalSinminustheFFglobalmarketfactor.Thisisanunusualprocedureasthemarketfactorappearsonbothsidesoftheregression.Indeed,themarketbetaofthezero‐investmentportfoliois‐0.7;butthisimpliesthattheTotalSinportfoliohasabetaofonly0.3.ThelowbetasuggeststhattheFFglobalfactordoesnotsufficientlycaptureaveragereturns.Usingtheaprioriexpectedbetaof1andtheaverageglobalfactorreturnovertheperiodof0.44%permonth(obtainedfromKenFrench’datalibrary),theabnormalreturnwouldbelowerbyaround31bp.permonth(‐0.7x44).Intable3,theoutperformancewouldthenbe60bp.permonth.Thisisstillquitelarge,butgiventhelargestandarderrors,unlikelytobesignificant.Still,thelargestandarderrorsareanothermanifestationofthepoorfitoftheFF‐4factormodel.Overall,thisillustratesthedifficultyofsimplyapplyingaglobalfactormodeltostockslistedacrosstheglobe.TheapproachofFabozzi,MaandOliphant(2008)ofusingnationalmarketreturnsappearstoprovidesuperiorbenchmarks.

Insum,theresultsinTrinksandScholtens(2017)suggestthatreturnsofsinstocksareveryhigh.However,resultsshouldbeinterpretedwithcautiongiventhelackofagoodbenchmarkmodel.

PerhapsthemostinterestingandrevealingstudyofexclusionaryscreeningisHoepnerandSchopohl(2016,JBusEth,ABS3NF).HSstudytheperformanceofstocksexcludedfromtheSwedishAP‐fundsandtheNorwegianGovernmentPensionFund‐Global(GPFG)duringtheperiod2001‐2015.Thescreeningprimarilynorm‐basedratherthansector‐based.Thatis,itismostlyconductedbasedonviolationsofinternationalnormsregardingenvironmental,humanrightsorlaborrightsissuesortheproductionofcontroversialweapons.Asector‐basedscreeningisperformedonlyforthetobaccoindustryfortheGPFGin2009‐2015.

HSnoteintheabstractthatthe"portfoliosofexcludedcompaniesdonotgenerateanabnormalreturnrelativetothefunds'benchmarkindex".However,theresultsofthepaperdonotsupportthisclaim.Table3showsthemainresultsforthesixportfoliosanalyzed,namelythevalue‐andequal‐weightedportfoliosoftheexcludedstocksinAP7,AP1‐4andGPFG.PanelAshowsthattheCAPMalphasforthesixportfoliosareuniformlypositive,andtheoneofthealphasissignificantatthe1%levelwhilefurthertwoalphasaresignificantatthe10%level.Moreover,amongtheinsignificantalphas,thesmallestvaluecorrespondstoanabnormalreturnof4.15%peryearoftheexcludedstocks(forAP1‐4value‐weighted).Whileonecannotrejectwith90%confidencethehypothesisthatthisportfoliodoesnotgenerateabnormalreturns,calculationsshowthatonecanalsonotwith90%confidencerejectthehypothesisthattheabnormalreturnsaredifferentfrom10%peryear.Indeed,thestandarderrorsofthealpha

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estimatesfortheAP1‐4portfoliosareroughlytwiceaslargeasthoseoftheAP7portfolios,whilethepointestimatesaresimilarbetweenAP1‐4andAP7.Hence,wearenotsurprisedthatresultsforAP7aresignificantwhiletheyareinsignificantforAP1‐4.TwoissuesseemtodrivethehighstandarderrorsforAP1‐4.First,thesampleperiodislongerasAP7coversnearly14yearswhileAP1‐4coversjust9yearsand1month.Secondly,theAP1‐4portfolioisverysmallcompassingbetween2and20stockswhiletheAP7portfolioincludesbetween19and54stocks.Indeed,table3showsthatthemarketfactorexplainsmuchlessofthetimeseriesvariationinAP1‐4thaninAP7.Inshort,thepowerofthetestfortheAP1‐4stocksismuchlowerthanforAP7stocks,hencewearenotsurprisedtofindsignificantresultsforAP7,butnotforAP1‐4‐evenwhenthealphaestimatesareverysimilar.Moreover,thestandarderrorsoftheGPFGportfoliosarein‐between,andindeedthelevelofsignificanceisin‐betweenthoseofAP1‐4andAP7.8

Thedifferencesinpoweracrossthe3portfoliosexistbyconstruction:arisingfromthewaythattheauthorsconstructtheportfolios.Itmakesnosensetotreattheseportfoliosequallywhensubsequentlymakinginferences.

Mostimportantly,thekeytestwithmaximumpowerisconspicuouslyabsent.Onecaneasilyconstructtheportfolioconsistingofallexcludedstocksacrossthethreesub‐portfolios.Theabnormalreturnsfortheequallyweightedportfoliowouldbearound5%peryearandthatofthevalueweightedportfoliowouldbearound4%peryear.Becauseoftheaddedpower,thealphaestimatesforbothportfoliosarehighlylikelytobestatisticallysignificant.

OtherstudiesthatfindoutperformanceofsinstocksincludeStatmanandGlushkov(2009),Filbeck,HolzauerandZhao(2014),andHumpfreyandTan(2014).Thesestudiesarediscussedbelow,astheyalsocoverotherESGinvesting.ArecentarticleisLobeandWalkshäusl(2016,RMS,ABS0NF).Thatpaper,appearinginanon‐ABSratedjournal,generallyfindsnoeffects.However,thesampleselectionappearspeculiar,astheperiodcoversonly1995‐2007evenwhenthepaperwasnotacceptedforpublicationbeforeOctober2014,leavingalonggap.Finally,Duran,KohandTan(2013,PBFJ,ABS2F)providesomeevidencebasedonsevenPacific‐Basinmarketsthatholdingsandreturnsdependontheculturalnormofthecountry.9

8Asimilarlineofargumentationholdsforthe4‐factorsalphasintable3B.9Inanon‐academicstudy,Junkin(2015)estimatesthehistoricalcostsofexcludingtobaccostocksandothersecuritiesfromCalPERS’portfoliotocorrespondtoapresentvaluebetween$3.7and$8.3bn.

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2.2 Evidence based on ESG ratings using positive/negative screening 

ThereisevidencethatstockwithhighESGratingsexhibithighfuturereturns.Theevidenceisstrongestin1991‐2004,whilethereturnsofstockswithhighESGratingsdonotappeartodifferfrombenchmarksin2005‐2012.Someevidencesuggeststhatreturnsagainhavebeenhighsince2012.

SeveralcompaniesprovideESGratingsforinvestors.Typically,theproviderwillratefirmsalonganumberofdimensions,whichcanbegroupedintothethreeESGelements.ItisthenstraightforwardtoconstructportfoliosbasedonacompositemeasureeitherwithineachESGelementoranoverallESGmeasure.ThefirstsuchproviderwasKLD(nowMSCI)thatinitiatedratingsin1990,thusprovidingthelongesttimespanforassetpricingtests.TheinitialworkusingKLDdatagenerallyfindsapositiverelationshipbetweenratingsandreturns.KempfandOsthoff(2007,EFM,ABS3F)constructlong‐shortvalue‐weightedportfoliosfromtheS&P500andDS400stocksintheperiod1992‐2004.Theyfindsignificantlypositive4‐factoralphasofaround5%peryearusinga10%cut‐off(table5)ofindustry‐adjustedESGscores.StatmanandGlushkov(2009,FAJ,ABS3F)generallyconfirmthefindingsofKempfandOsthoff(2007)basedon1992‐2007data.Bothstudiesalsofindthatportfoliosformedoncommunityandemployeerelationsexhibitthehighestreturns,whilediversity,environment,productsandhumanrightsdonotappeartoaffectreturns(KOtable5,SGtable3).

Borgers,Derwall,KoedijkandterHorst(2013,JEF,ABS3F)showthattheESGoutperformancedisappearsaftertheinitialsampleperiodinKempfandOsthoff.Also,theyshowevidencethatthehighreturnsintheinitialsampleperiodwereduetomarketunderreaction.

BDKHstudytheperiod1991‐2009andusevariousESGcut‐offpointstoformlong‐shortvalue‐andequal‐weightedportfolios.Four‐factoralphasarepositiveandsignificantuntil2004afterwhichtheyareclosetozeroandinsignificant.TheresultsarerobusttochangesintheESGmeasure,includingtoindustry‐adjustments.

AsbenefitstoESGareinitiallyintangible,theabnormalreturnsmightappearbecausethemarketfailstofullyincorporateintangibleinformation.Pricesaresubsequentlycorrectedastheintangibleinformationeventuallybecometangiblethroughhigherearnings.UnderthishypothesiswewouldexpectthatearningsofhighESGfirmssurprisepositively,hencethatreturnsaroundearningsreleasesarehighandthatactualearningsarehigherthanfinancialanalysts’estimates.Indeed,BDKHfindtheESGindexisrelatedpositivelytobothearningsannouncementreturnsandsurpriseinanalyst’earningsforecastsuntil2004.Inthe2004‐2009period,therelationshipdisappearsforearningsannouncement

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returns,whileitismixed(positive,negative,ornoeffectdependingonthespecification)foranalysts’forecasts.Overall,theresultssuggestthatinvestorsbecameawareofpotentialbenefitstoESG,hencetheunderreactioninthefirstperiodseemstohavedisappeared.

HalbritterandDorfleitner(2015,RFE,ABS1F/NF)performananalysissimilartotheportfolioreturnpartofBDKH.TheydoconfirmthefindingsofinitialoutperformancefollowedbyinsignificantESGreturnsinthesubsequentperiod.HalbritterandDorfleitneralsoinvestigatethereturnstoESGscoresprovidedbytwoothercompanies,ASSET4andBloomberg.Thosesamplesonlycoverthemorerecentperiods,namely2003‐2012forASSET4and2006‐2012forBloomberg.AlphasaregenerallyalsoinsignificantforportfoliosconstructedbasedontheASSET4orBloombergdata,confirmingtheKLDresultsforthelaterperiod.However,HalbritterandDorfleitneralsoconductFama‐MacBethcross‐sectionalregressions(table7).Thistestingprocedureyieldsquitedifferentresults:WhileKLDscoresremaininsignificant,theESGscoresofASSET4andBloombergarebothhighlysignificantandpositive.Thatis,firmswithhigherASSET4andBloombergESGscoresexhibithigherfuturereturns.TheFama‐Macbethprocedureentailsusingthefullsample,appliesadifferentweightingscheme,andutilizescontrolsbasedoncharacteristicsratherthanfactorloadings.Still,resultsareusuallyconsistentwiththosefromfactorregressionsinotherapplications.Therefore,thedifferenceobservedinthecurrentsampleisunusual.TheanalysisinHalbritterandDorfleitnerdoesnotallowforidentificationofthesourceofthedifferenceinresultsbetweentheFama‐MacBethcross‐sectionalregressionsandtheportfoliofactorregressions.Itwouldbeusefulforfutureworktoreconciletheresults,forinstancebyanalyzingtherobustnesswithrespecttochangesinregressorsorfactors.

Insum,ESGscoreswerepositivelyrelatedtofuturereturnsinthe1990s,theeffectseemstohavedisappearedinthe2000s.Still,thegoodnewsforESGinvestorsisthathighESGscoreshavenotleadtolowerfuturereturnsintheperiodupto2012.Thisreviewerhasnotseenstudiesofrisk‐adjustedreturnsbasedonESGscoresintheperiodafter2012.However,Larsen(2016,F/I,ABS0)reportsastrongpositivecorrelationbetweenMSCI(formerlyKLD)scoresandrealizedreturnsduring2012‐2016(table2).Moreover,Larsenfindsthatstockswithhighscoresexhibitalowerstandarddeviationofreturns.ThisispromisingforESGinvestors,anditwouldbeusefulalsotoseealphas,i.e.,returnsadjustedforsystematicrisk.

HumphreyandTan(2014,JBusEth,ABS3NF)usetheKLDratingsandSICcodestoconstructfourSRIportfoliosbasedonpositiveandnegativescreening.Thesampleperiodis1996‐2010.Thetwonegativescreensexcludebasedontobacco,alcohol,gambling,weaponsandnuclear.Relativelyfewstocksare

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excludedinthenegativescreen,sothereisalargeoverlapbetweentheSRIandthebenchmarkportfolios,whilethetwopositivescreensselectaboutone‐thirdofthefull‐samplestocks.Table3showsthattheSRIportfoliobasedonnegativeSICscreensunderperformintheone‐factorandfour‐factormodelsatthe5%level,whileotherthreeSRIportfolioreturnsarealllowerthan,butinsignificantlydifferentfrom,thebenchmarkreturns.10Table4comparesSharperatios.Alldifferenceshereareinsignificant,eventhoughtheunscreenedportfolioexhibitsanannualizedSharperatioof0.298whilethetwoSRIportfolioswithpositivescreenshaveSharperatiosof0.251and0.255.11Thus,thetestpowerdoesnotappeartobehigh.

Whilethesampleperiodisofareasonablelength,itissurprisingwhyHTdonotstartthesamplein1992whenKLDdatabecameavailable.Indeed,StatmanandGlushkov(2009)andFilbeck,HolzauerandZhao(2014,JoI,ABS0)bothfindthatKLD‐definedsinstocksoutperformwhenthesamplestartsinthatyear.

2.2.1 Environmental screens 

Theevidenceoninvestorreturnstoenvironmentalscreensislimitedandtheresultsaremixed.

Derwall,Guenster,BauerandKoedijk(2005,FAJ,ABS3F)studythereturnstoastrategybasedonInnovestStrategicValueAdvisors’corporateeco‐efficiency.Theyfindthatmoreeco‐efficientfirmsexhibithigherstockreturnsthantheirlesseco‐efficientcounterpartsovertheperiod1995‐2003.Giventheveryshorttimeperiod,itisnotsurprisingthattheresultsarenotrobust.Specifically,long‐shortalphasareonlysignificantinthe4‐factormodel(atthe5%level),whereasthe1‐factoralphaisinsignificant.Moreover,theauthorsbackfilldataastheyonlyhaveInnovestscoresstartingin1997.Thisisnotstandardprocedureinfinanceresearch,asitcanintroduceseverelook‐aheadbiases.12Guenster,Bauer,DerwallandKoedijk(2010,EFMABS3F)correlatetheInnovesteco‐efficiencydatawithmeasuresofoperatingperformanceandequityvaluation.Theyfindthateco‐efficientfirmsbecomerelativelymoreexpensive,asmeasuredbyTobin’sq,duringthesampleperiod.Thissuggests

10TheauthorsdiscounttheunderperformanceoftheSICscreenedportfolios,notingthat“Wesuspect,however,thatthesignificanttstatisticismoreanartefactoftheminisculestandarderror[…]ratherthandenotinganyrealevidenceofunderperformance.Thesetinystandarderrorsareattributabletothealmostidenticalreturnseriesofthetwouniverses”.Becausefewstocksareexcludedthereturnserieswillbeverysimilar;however,thiswillalsoaffectthereturndifferences,thusthet‐statisticandthecorrespondinginferencesarestillvalid.11Bycomparison,Auer(2016,table4)obtainsap‐valueofjust0.02inatestforthedifferenceinSharperatiosbetween0.558and0.589usingashortersampleperiod.TheAuerstudyisdiscussedinsection2.2.3.12Theauthorsareawareoftheissueandnotethat”resultswhenweusedrealdataforthe1997‐2003periodaresimilartothosereportedhere.”However,presumablyresultswereweaker.Otherwise,therewouldbelittlepointinbackfilling.

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thatthereturnoutperformanceofthe2005studywasduetochangesinvaluation:eithereco‐efficientfirmswereinitiallyundervaluedortheybecameovervaluedduringthesampleperiod.

TheevidenceonreturnstoanenvironmentallyconsciousinvestmentstrategybasedonKLDscoresiscontradictory.HalbritterandDorfleitner(2015,table6)findthatalong‐shortportfolioyieldsa4‐factoralphaof6.6%peryearduring1990‐2001–significantatthe1%level,whilethestrategyobtainsnegative,albeitinsignificant,alphasin2002‐2012.IncontrasttothepositiveresultsinthefirstpartoftheHalbritterandDorfleitnerperiod,KempfandOsthoff(2005)andStatmanandGlushkov(2009)findnoevidenceofoutperformancebasedonKLDEscoresduringlargelyoverlappingperiods.

2.2.2 Social screens 

Thereisevidencethatinvestorreturnstoatleastonesocialscreen,namelyemployeesatisfaction,werehighduring1984‐2011.

Edmans(2011,JFE,ABS4*F)convincinglyshowsthatfirmswithhighemployeesatisfactionexhibithighfuturestockreturns.Asthepapernotes,a“value‐weightedportfolioofthe‘100BestCompaniestoWorkForinAmerica’earnedanannualfour‐factoralphaof3.5%from1984‐2009,and2.1%aboveindustrybenchmarks.Theresultsarerobusttocontrolsforfirmcharacteristics,differentweightingmethodologies,andtheremovalofoutliers.”Theanalysisappearstobecarefullyexecuted.Inparticular,characteristic‐adjustedreturnsareused.Inthisprocedure,returnsofsimilarstocksaresubtractedfromtheteststockbeforerunningfactorregressions.ThisallowsforcontrolsforinteractioneffectswhichcouldotherwiseresultintheFama‐Frenchmodelmispricingcertainstocks.Also,Fama‐MacBethregressions(table6)confirmresultsofthefactorregressions.Edmans(2012,AMP,ABS3NF)extendsthesampletocover1984‐2011withalmostidenticalresults.

Employeesatisfactionisanintangiblevariable,anditcanbenefitshareholdersthroughemployeemotivationandretention.Edmansarguesthattheabnormalreturnsappearbecausethemarketfailstofullyincorporateintangibleinformation.Pricesaresubsequentlycorrectedastheintangibleinformationeventuallybecometangiblethroughhigherearnings.Consistentwiththishypothesis,hefindsthattherealizedlong‐termearningsgrowthofthe“BestCompanies”ishigherthananalysts’forecast5yearsearlier(relativetoothercompanies).Moreover,thehighreturnspersistupto4yearsaftertheportfolioformationdate(table9).

Asnotedearlier,KempfandOsthoff(2005)andStatmanandGlushkov(2009)foundhighreturnstoastrategybasedonKLDscoresonemployeerelations(andcommunity).TheseresultsarethusconsistentwithEdmans(2011,2012).

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2.2.3 Governance screens 

GoodgovernancefirmsasmeasuredbytheG‐indexhadhigherreturnsthanpoorgovernancefirmsin1990‐1999.However,thereturndifferencedisappearedinthesubsequentperiod.Someevidencesuggeststhatothermeasuresofgovernancepredictreturnsinthesubsequentperiod,buttheevidenceisnotconclusive.

Inaseminalpaper,Gompers,IshiiandMetrick(2003,QJE,ABS4*F/NF)constructafirm‐levelgovernanceindex,G‐index,basedon24provisionsthatweakenshareholderrights.Afirmwithweakshareholderrightswouldhaveadaptedmanyprovisions,hencehaveahighG‐index,whileafirmwithstronggovernancewouldhavealowG‐index.Forasampleof1500largeU.S.firmsduring1990‐1999,theyfindthataportfoliolongthe10%lowestG‐indexfirmsandshortthe10%highestG‐indexfirmsearnedanabnormalreturnof8.5%peryear.

Bebchuk,CohenandWang(2013,JFE,ABS4*F)extendthesampleperiodofGompers,IshiiandMetricktocover1990‐2008.Theyshowthattheabnormalreturnsareinsignificantduring2000‐2008.Thissuggeststhattheeffecthasdisappearedaftertheoriginalsampleperiod.Still,becauseoftheshorttimeperiod,theassetpricingtestshavelowpower.Infact,amodifiedgovernanceindex(theE‐index)yieldslong‐shortreturnsyieldsa4‐factoralphaof3.1%peryearwhenvalue‐weightedand4.2%peryearwhenequal‐weighted.Thus,whileinsignificantlydifferentfromzero,theresultswouldalsobeconsistentwithrelativelyhighreturnsbasedonthegovernanceindex.

NeitherGIMnorBCWfindevidencethatgoodgovernancefirmsaremorerisky.Therefore,thehigherreturnsappeartobeamarketanomaly.Arguably,investorsinthe1990sweresimplynotawareofthedetrimentaleffectsofthegovernanceprovisions,manyofwhichhadbeenimplementedinthe1980s.However,becauseofthegreaterfocusongovernanceinthe2000s,investorshadbecomeawareoftheeffects.Consistentwiththislearninghypothesis,BCWfindthatgoodgovernancefirmstendtoreportmorepositiveearningssurprisesthanpoorgovernancefirmsinthe1990s,butthatthisrelationshipdisappearsinthe2000s.

Whiletheresultsindicatethatthepricingeffecthasdisappearedafter2001,BCWshowthatgoodgovernancefirmsstilltendtohavehighervaluation,profitabilityandgrowth(table8)inthelaterperiodthandopoorgovernancefirms.Whilethecorrelationbetweengovernanceandtheseperformancemeasuresdoesnotresolvethedirectionofthecausalrelationship,theydoimplythatgovernancecanbeusedasanindicatorofperformance.

GuandHackbarth(2013,RoF,ABS4F)showthattherelationshipbetweengovernanceandstockreturnsidentifiedinGompers,IshiiandMetrick(2003)is

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concentratedamonghightransparencyfirm,asmeasuredbythedistributionofanalysts'forecasts.AsGuandHackbarthnote,thisisconsistentwiththeviewthathighlytransparentfirmsaremorevaluabletakeovertargets,becauseacquirerscanbidmoreeffectivelyandidentifysynergiesmoreprecisely.Bycontrast,theresultsarenotconsistentwiththeviewthatoutsideinvestorscannotmonitoropaquefirmseasilyhencethosefirmswouldbenefitmorefromgoodgovernance.

Inthe2000‐2011period,alongwiththeinabilityoftheG‐indextopredictreturnsintheoverallsample,therelationshipisalsoinsignificantforhightransparencyfirms(table6).However,itremainspossiblethatadifferentialeffectremainsacrosslevelsoftransparency(asallsixlong‐shortportfoliosintable6Eexhibithigherreturnsforhightransparencythanforlowtransparencyfirms,notestsforsignificanceofthesedifferencesarereported).

Basedon2004‐2012dataofSTOXX600(largeEuropeanstocks)andESGratingsfromSustainalytics,Auer(2016,JBusEth,ABS3NF)studiestheeffectofexclusionaryscreeningonportfolioSharperatios.DuringthesampleperiodSustainalyticsratedstocksonlyinresponsetoinvestorrequests.While520of892stockswereratedatsomepoint,noinformationisprovidedonhowmanystockswereratedatgivenpointsintime.Presumably,fewstockswereratedatthebeginningofthesampleperiod.

Themainresult(table4)isthattheSharperatiooftheratedstocksincreaseswhenexcludingstockswithpoorGovernancerating(significantatthe5%level),whileexclusionaryscreeningbasedonEandSdoesnotaffectSharperatios.13

TheusageofSharperatiosratherthanalphasassumesthatthattheinvestor’soverallportfolioconsistsofthebenchmarkportfolio(consistingoftheratedstocks).Iftheinvestorholdsamorediversifiedportfolio,theusualalphaanalysiswouldbemoreappropriate.Whilenodirectinformationisgivenontherisk‐returnoftheexcludedportfolios,onecaninferfromtable4thatthe20%lowestgovernance‐ratedstockshadayearlyaveragereturnof1.7%lessthantheremaining80%.Onecannotcomputedifferencesinriskasthisdependsonthecovariancestructure,buttheportfolioriskdoesfallwhenexcludingthelowestG‐ratedstocks.

Thesampleperiodisveryshort,thuspowerofthetestsislow,sotheinsignificantresultsforEandSscreeningisnotsurprising.Moreover,theperiodincludesthefinancialcrisis,whichlikelywilldominateinparticularthevolatility

13AueralsonotesthattheportfolioofratedstockshasahigherSharperatiothanthefullsample,butsincewedonotknowwhethertheunratedstockswouldhavehadrelativelyloworhighratings,wecannotconcludewhetherthisindicateshighorlowreturnsforhighESGstocks.

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estimates,thustheSharperatios.Indeed,figure3showsthatSharperatiosdivergeduringthefinancialcrisis.Nonetheless,itisnotablethatGovernanceratingsappeartopredictSharperatios.

2.3 Stock market reactions to ESG events 

EventstudiesindicatethatthestockmarketdoesnotrespondpositivelytoESG/CSRinitiativesbyfirms.Whiletheresultssuggestthatagencyissuesareagenuineconcern,theyalsosuggestthatsuchconcernscanbemitigatedthroughsoundcorporategovernance.

EventstudiescanprovidepowerfulanalysesofthevaluetoESG/CSRpolicies.Adifficultywithlong‐termreturnstudiesistheassumptionthatwehaveidentifiedthecorrectassetpricingmodel.Often,studiescanbecriticizedonthegroundsthatanapparentabnormalreturniscausedbyalatentriskfactor,i.e.,thatthestudydoesnotproperlyaccountfordifferencesinrisk.Becauseeventstudiesmeasurereturnsovershorttimewindowsofafewdays,the(risk‐driven)expectedreturncomponentistypicallynegligible.Also,testpowerifoftenhighbecausethevolatilityofreturnsislowovershorttimewindows,thusmakingiteasiertoestablishthestatisticalsignificanceofanyrelationship.14

Afewstudieshaveusedeventstudiestoinvestigatethestockmarketresponsetochangesinfirms’environmentalpolicies.Fisher‐VandenandThorburn(2011,JEEM,ABS3NF)studytheabnormalstockreturnsaroundannouncementsthatfirmshavejoinedtwovoluntaryenvironmentalprograms,namelytheU.S.EnvironmentalProtectionAgency’sClimateLeadersprogramandCeres.TheClimateLeaderscorporatepartnerssetspecific5‐10yeargoalsforthereductionofgreenhousegasses,whilemembershipofCeresinvolvesadaptingenvironmentallyconsciouscodesofconduct.Thesampleincludes117announcementsbylargeU.S.firmsbetween1993and2008.Theresultsshowadropinmarketvaluesbyaround1%whenfirmsjointheClimateLeadersprogram–notonlystatisticallysignificant,butalsoeconomicallysignificantasitcorrespondstoanaveragelossof$3billion!Moreover,whenfirmsannouncetheirspecificreductiontargetstheirmarketvaluesdropbyanother1%.Bycontrast,whenfirmsjoinCeresabnormalreturnsareinsignificant.

Probitanalysisshowsthatfirmswithahighnumberofshareholderresolutionstowardclimateactionandfirmswithpoorcorporategovernancescore(asmeasuredbytheG‐indexdiscussedearlier)aremorelikelytojointheClimateLeadersprogram.Moreover,returnsaresignificantlymorenegativeforfirmswithapoorcorporategovernancescore,suggestingtheexistenceofagencyproblems.Inparticular,asdiscussedinsection1.1.1managersmightseektoenhancetheirpersonalrecognitionorexpresstheirsocialpreferencesviaESG

14Highervolatilityimplieslowertestpower,andvolatilityincreaseswiththesquarerootoftime.

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initiativestothedetrimentofshareholdervalue.Astheauthorsconclude,“thus,itseemsthatfirmsareenteringtheClimateLeadersprogramdespitetheprospectofloweringshareholdervalueeitherbecausetheyarefacinginstitutionalpressurestodoso,orbecausemanagersfacelessshareholderoversight,allowingthemmorediscretiontomakethesetypesofvoluntaryenvironmentallyresponsibleinvestmentdecisions.”

Jacobs,SinhalandSubramaniam(2010,JOM,ABS4*NF)examinethestockmarketreactiontotheannouncementofvarioustypesofcorporateenvironmentalinitiatives,includingenvironmentalbusinessstrategies,environmentalphilanthropy,voluntaryemissionreductions,econ‐friendlyproducts,renewableenergy,andrecycling.Theymostlyfindinsignificantresults,exceptforvoluntaryemissionreduction,forwhichtheyalsofindsignificantlynegativereturnsconsistentwithFisher‐VandenandThorburn,andforenvironmentalphilanthropy,forwhichtheyfindsignificantlypositivereturns.

Krüger(2015,JFE,ABS4*F)studiesthestockmarketresponseto2,116corporateeventidentifiedbyKLDaseithernegativeorpositivealonganESGdimension.HefindsasignificantlynegativeresponsetonegativeESGevents.However,thisisnotsurprising,asthenewsoftenimplynegativecashflows,forinstanceaproductrecalloracourtdecisionagainstthecompany.ESGeffortsmaystrivetominimizetheoccurrenceofsuchevents,butmeasuringreturnstonegativeeventsdoesnotaccountforthecostsofthisminimization.Ofcourse,thequestionforinvestorsiswhethertheneteffectofESGeffortsispositive.

ThepositiveESGeventsseemtobemoreforwardlooking,e.g.,aninvestmentinanESG‐relatedinitiative.Therefore,thesearemoreinformativeoftheeffectsofESGinitiatives.Overall,thestockmarketreactsslightlynegativelytopositiveESGevents.

Perhapsmoreinterestingly,Krügertheninteractstheresponsetomeasuresofagencyconcerns.Krügerusesbookleverageandliquidityasmeasuresofagencyconcerns,followingthefreecashflowtheoryofJensen(1986).Consistentwiththeagencytheory,hefindsanegativeeffectofliquidityandapositiveeffectofbookleverageonreturnsaroundpositiveESGevents.Moreover,thereisnointeractioneffectamongnegativeESGevents.BecausewewouldexpectnegativeESGeventstobelessrelatedtoagencyconflicts,thisreinforcestheagencytheory.

AsinFisher‐VandenandThorburn,overalltheseinteractioneffectssuggestthatmanagersmightseektoenhancetheirpersonalrecognitionviaESGinitiativestothedetrimentofshareholdervalue.UnlikeFisher‐VandenandThorburn,Krügerdoesnotdirectlyinteracttheresponsewithmeasuresofcorporategovernance.ItwouldbeveryinterestingtoseehowESinitiativesinteractwithgovernance.

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Onecritiqueofeventstudiesisthatothereventsmaybehappeningwithintheeventwindowthatcouldconfoundtheresults.Forinstance,apositiveESGeventcouldhavebeenacompanyresponsetosomenegativenewsaboutthecompany.Inthatcase,eveniftheESGeventistrulyvaluecreating,thestockmarketresponsemayseemnegativebecauseoftheconfoundingevent.15Whiletherelevanceofsuchcriticismishardtoevaluate,thestockmarketresponsedoesindeedappeartodependonearliernews.Specifically,KrügerfindsamorepositivestockmarketresponsetopositiveESGeventsifKLDhasregisteredanESGconcernwithinthelastyearforthecompany.Thisisespeciallytrueforemployeerelations,environmentandhumanrights.

Flammer(2013,AMJ,ABS4*NF)identifieseventsaseco‐harmfuloreco‐friendlybasedonwordsearchesintheFactivadatabase.AsintheKrügerstudy,eco‐harmfuleventscouldbeaccidents,suchasoilspills,withclearcashflowimplications.Indeed,thestockmarketreactionisnegative.ContrarytoKrüger,Flammerfindsapositivestockmarketreactiontoeco‐friendlyevents.However,whilemanyoftheeventsclearlyareenvironmentallyfriendly,suchasrecyclinginitiatives,othereventsarelessclearlyenvironmentallyfriendly.Forinstance,reportsonFebruary14,1991regardingtheExxonsettlementwithAlaskafollowingthe1989oilspillappeartobetreatedasaneco‐friendlyevent.Yet,theconservationgroupDefendersofWildlifedidnotviewthesettlementaseco‐friendly,notingonU.S.Newswirethat"[w]eareflabbergastedthatGov.HickelisattemptingtosettleclaimsagainstExxonforlessthan$1billion.Earlyoninthisprocess,conservationistsestimatedthat$5billionwouldbeneeded.Thecleanup,restoration,replacementandhealingarefarfrombeingcompleted.Muchoilstillresidesinsubsurfacesedimentsonmanybeaches,especiallythoseoutsidePrinceWilliamSound.Exxonhasacorporateresponsibilitytopaythefullcostsfordamage,response,andresolution."Surely,thesettlementwaspositivenewsforExxon’sstockprice,buthardlypositivenewsfortheenvironment.Suchprobablemisclassificationmakesitdifficulttointerpretthefindings.

2.4 Active ownership 

ThereisevidencethatactiveownershipbyESGinvestorscancreatevalue,bothforshareholdersandotherstakeholders

Theliteraturediscussedsofarhaveassumedthatinvestorsareactiveinselectingstocks,butthattheyarepassiveownerswhodonotdirectlytrytoinfluencemanagementbehavior.However,someESGinvestorsengageinactiveownershipviadirectcontactwithseniormanagementandbyexercisingownershiprightsatshareholders’meetings.15TheFisher‐VandenandThorburnstudyislesspronetosuchcriticismduetoashorterevent‐window,butitisalsomorenarrowlyfocusedthandotheKrügerstudy.

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Dimson,KarakasandLi(RFS,2015,ABS4*F)useaproprietarydatasetfromalargeinstitutionalESGinvestortostudytheeffectsofactiveownership.Thesampleconsistsof382successfuland1,770unsuccessfulengagementsfor613U.S.publiclylistedcompaniesduring1999‐2009.TheirresultssuggestthatESGactivismcanbevalueenhancing.Specifically,theyfindthatone‐yearcumulativeabnormalreturnsare7%onaveragefollowingsuccessfulengagement,whilethereisnomarketreactiontounsuccessfulengagements(figure1).WhencategorizingengagementsaseitherESorG,theyreportasimilarreturnresponsetothetwotypesofengagements.

Also,ROAimproveforsuccessfulengagementrelativetounsuccessfulones,albeitmainlyforESengagements.Furthermore,pensionactivistsandSRIfundsincreasetheirholdingsaftersuccessfulESengagements,consistentwiththeclienteleeffectofHongandKacperczyk(2009)forsinstocks.

AdrawbackoftheDimson,KarakasandListudyisthatthedataisfromasingleinstitutionalinvestorwhochosetosharethedata.Hadtheinstitutionanticipateddifferentresults,itwouldhavelessincentivetoshare.Thatis,otherinvestorsmightbelesssuccessfulpursuingactiveownership.Nonetheless,theresultsdemonstratethatactiveownershiponESGmatterscancreatevalue,bothforshareholdersandotherstakeholders.

2.5 Meta studies 

SeveralreviewarticlesandmetastudiesofESGinvestingexist.ThemostcomprehensiveintermsofnumberofstudiesisFriede,BuschandBassen(2015,JSusFinInv,ABS0)whoconductavote‐countandmeta‐studyof2200empiricalstudies.Theyfindthata“largemajorityofstudiesreportspositivefindings”ontherelationshipbetweenESGandcorporatefinancialperformance(CFP).Onthisbasis,theyconcludethat“theresultsshowthatthebusinesscaseforESGinvestingisempiricallyverywellfounded.”However,thereareatleastthreereasonstobeskepticaltowardsthisclaim.

First,someauthorsappeartofavorapositiveeffectofESGratherthanapplyinganobjectivescientificapproach.Thereareexamplesofstudiesneglectingaparticularrelationshipandexamplesoftendentiouslanguage.Biasesinthereviewstudies,thatformmuchofthebasisfortheFriede,BuschandBassenanalysis,wouldaggravateanybiasesintheindividualstudies.SomereviewstudiesexplicitlysetouttomakethebusinesscaseforESG,asforinstanceClark,FeinerandViehs(2015).Theyfindapositiverelationshipin94of110studies

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thattheysurveywhileonlyonehasanegativerelationship.However,thisreviewerfindsithardtoagreewithmanyofthe“positive”classifications.16

Secondly,thestudiesinvestigatetherelationshipbetweenESGandCFPofwhichstockreturnsisonlyoneofmanyvariables.TheCFPisoftenanaccountingvariablesuchasROAorROE.However,asdiscussedinsection1.2,thatsoundESGdecisionsaresoundbusinessdecisionsdoesnotimplythatinvestorsobtainsuperiorreturnsfrominvestinginthesefirms.Ofcourse,thisdependsonwhethertheinformationisalreadypricedintothestock.OnlyifthestockmarketsystematicallyundervaluessuchinformationwilltheESGinvestorobtainhighreturns.

Thirdly,asalsonotedinsection1.2,itisnotoriouslydifficulttoinfercausalityfromcorrelationsbetweendifferentcorporatevariables.AfirmwithahighESGscoremighthavehighprofitability,butthehighprofitabilitymightbedrivingtheabilitytoinvestinESGratherthantheESGinvestmentscausinghighprofitability.Toavoidsuchissuesofreversecausality,oneneedstoidentifyexogenousvariationintheESGvariable,ratherthansimplyshowingacorrelationbetweenthetwovariables.ThiscausalityissueisusuallynotaddressedintheCSRliterature.

Friede,BuschandBassennote[p.226]thatthey“clearlyfindevidenceforthebusinesscaseforESGinvesting.Thisfindingcontrastswiththecommonperceptionamonginvestors.Thecontraryperceptionofinvestorsmaybebiasedduetofindingsofportfoliostudies,whichexhibit,onaverage,aneutral/mixedESG–CFPperformancerelation.”Aplausiblealternativeinterpretationisthatinvestorsarenotbiased,butthattheyunderstandthatthefindingsfromportfoliostudiesaremorerelevantformakingthebusinesscaseforESGinvesting.

3 Conclusion and discussion of the findings TheliteratureonESGinvestinghasbeenprolificduringthelastdecade.Theliteratureisforthemostpartmethodologicallysound,butsomeauthorsdoappeartowishtomakethebusinesscaseforESGinvestingratherthanapplyingamoredispassionatescientificapproach.Thishasnecessitatedarathercarefulevaluationoftherelevantarticles.BecausetherearemanydimensionstoESG16Forinstance,Fisher‐VandenandThorburn(2011)iscountedaspositive,contrarytotheauthorsconclusionthat“theresultsindicatethatvoluntaryenvironmentallyresponsibleinvestmentsofthiskindconflictwithfirmvaluemaximization.”Likewise,Krüger(2015)andCapelle‐BlancardandLaguna(2010)arerecordedaspositivebecausethenegativeeventsyieldnegativestockmarketresponses,butthesearesimplynegativecashfloweventsandonewouldhavetoknowthecostofloweringtheprobabilityofsuchevents.Further,thereisdouble‐countingofpositivestudiesbasedonthesamedata,suchasEdmans(2011,2012)andthegovernanceindexstudies,whileresultsonsinstocksareignored.

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investing,itisnotsurprisingthatnosimpleanswerexiststothequestionoftheprofitabilityofESGinvesting.

Overall,themostconsistentfindinginthecurrentreviewisthatsinstocksexhibitoutperformance.Thisimpliesthatsector‐basedexclusionslowerexpectedportfolioreturns.Inturn,thiscreatespotentialconflictsforinstitutionalinvestorsandinparticularwithinpensionfundsintowhichindividualsaversarelocked.First,therecouldbeaconflictbetweenthepersonalvaluesoftheportfoliomanagerandherfiduciaryresponsibilitytowardssavers.Moreover,itcreatesaconflictofinterestbetweenindividualsaverswithdifferentpreferencesandvalues.Ifsolutionsaretobefoundforsuchconflicts,pensionfundswouldbewelladvisedtoacknowledgeratherthanignoretheseconflicts.17

Highexpectedreturnstosinstocksimplythatthesefirmsexperienceahighercostofcapital.Assuch,theexclusionsdoachieveapresumedgoal.Ifonlysomefirmsexperienceahighercostofcapitalbecause,say,theyareshunnedbyinvestorsbecauseoflowESGscores,thenthosefirmswillbeatacompetitivedisadvantage.However,sinstocksaredefinedattheindustrylevel,suchastobacco.Therefore,theeffectofsinstockexclusionsistoraisethegeneralcoststofirmsintheindustrywithoutchangingtherelativecompetitivenessofthefirms.Customerswouldthusbearthecostthroughhigherprices.Assuch,portfolioexclusionisakintolevyingataxontheproduct,sayacigarettetax.Thedifferencefromanordinarytaxisthatthebeneficiariesofthose“taxrevenues”aretheinvestorswhochoosetoinvestintobaccofirms.Presumably,thisisnotanintendedconsequencefromESGinvesting.

ThereisevidencethatstockwithhighESGratingsexhibithighfuturereturns.Theevidenceisstrongestin1991‐2004,whilethereturnsofstockswithhighESGratingsdonotappeartodifferfrombenchmarksin2005‐2012.Someevidencesuggeststhatreturnsagainhavebeenhighsince2012.

Theevidenceoninvestorreturnstoenvironmentalscreensislimitedandtheresultsaremixed.Therearealsorelativelyfewstudiesontheeffectofsocialscreens.However,investorreturnstoatleastonesocialscreen,namelyemployeesatisfaction,werehighduring1984‐2011.

GoodgovernancefirmsasmeasuredbytheG‐indexhadhigherreturnsthanpoorgovernancefirmsin1990‐1999.However,thereturndifferencedisappearedinthesubsequentperiod.Someevidencesuggeststhatothermeasuresof

17Adetaileddiscussionofpossiblesolutionsisoutsidethescopeofthisreport.However,onepossibilityistodecomposeexpostportfolioreturnsaccordingtodifferentsindimensions,andoffersaversthepossibilityofmakingoffsettingactions,suchasdonatingtoaparticularcause.Analternativewouldbetocreatevariousportfolioswithinthepensionfondtowhichsaverscouldchoosetojoin.

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governancepredictreturnsinthesubsequentperiod,buttheevidenceisnotconclusive.

Usingearningsannouncementreturns,studiessuggestthatthestockmarketinitiallyunderreactedtotheinformationcontainedinESGratingsandtogovernanceinformation,butthatthisunderreactiondisappearedinthe2000s.Ifcorrect,thenESGinvestorsshouldnotexpectoutperformancebasedonportfolioconstructionwithESGratings.Ontheotherhand,thereispresentlynoempiricalevidencetosuggestthatsuchportfolioconstructionwillleadtolowerperformance(exceptforsectorexclusions).

EventstudiesindicatethatthestockmarketdoesnotrespondpositivelytoESG/CSRinitiativestakenbyfirms.Whiletheresultssuggestthatagencyissuesareagenuineconcern,theyalsosuggestthatsuchconcernscanbemitigatedthroughsoundcorporategovernance.TheseresultsareconsistentwiththetheoreticalconsiderationsontheinteractioneffectsofESandGoutlinedinsection1.1.1inthatthevalueofESinitiativesdependsongovernance.ThelessonforESGinvestorsisthatahighESratingisapositivesignaliftheGratingisalsoishigh,butanegativesignaliftheGratingislow.Still,theevidenceonthisinteractioneffectisstilllimitedandisbasedoneventreturnsratherthanlonger‐termportfolioreturns.Morestudiesareneededbeforemakingfirmerconclusionsregardingtheinvestmentcase.

Finally,thereisevidencethatactiveownershipbyESGinvestorscancreatevalue,bothforshareholdersandotherstakeholders.Specifically,successfulESGengagementsbyalargeinstitutionalinvestorintoU.S.firmswerefollowedbyabnormalreturnsinthesubsequentyear.Likewise,accountingperformanceimprovedfollowingsuccessfulengagements.Becauseoftheproprietarynatureoftheengagementdata,theevidenceisstilllimited,butclearlyencouragingforESGinvestorspursuingactiveownership.

RecentyearshavewitnessedaspectaculargrowthinESGinvesting.Therefore,anypastevidenceshouldbeinterpretedwithadditionalcaution.Thenatureoffinancialmarketsissuchthatasaninvestmentstrategybecomeswidespread,abnormalreturnseventuallydisappearorbecomenegative.SimpleconditioninginformationsuchasESGratingsusedbymanyinvestorsismostsusceptibletothiseffect.Therefore,theuseofmoresubtleESGinformationandactiveownershipmightbeamoreeffectivestrategyforthecommittedESGinvestorinthelongrun.

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