The Sustainable Investing Proposition.

• Author: Hong, Harrison

In a recent, widely covered press release, Larry Fink, chief executive of the world's largest asset management company, BlackRock, pledged significant resources toward developing sustainable investing, for example by offering funds that invest using environmental, social, and governance (ESG) criteria along with other considerations to make asset allocation decisions. (1) Fink said he views sustainable investing as being in its early stages. The thinking goes that investors worried about climate change increasingly want portfolios of companies that are consistent with their values--much in the way that an earlier generation embraced ethical investing or divestment-from-sin stocks. To the extent that markets are too short-termist to confront long-run risks, high ESG stocks might have high risk-adjusted returns. Depending on how large these excess returns are, a fund portfolio tilted toward high ESG stocks might outperform, or at least not underper-form, passive indices. This is what I label the "sustainable investing proposition."

This proposition is controversial among academics and practitioners. Since ESG funds typically have higher fees (due to the costs of in-house research or licensing third-party sustainability scores) and tracking error (since the mandate often requires tilting away from large market capitalization stocks), it is far from a foregone conclusion that ESG scores contain enough expected return information to overcome these initial drags on performance. Indeed, the performance of funds currently using sustainability scores generated by leading ESG ratings agencies is mixed.

Academic studies have found similarly divergent results on whether picking stocks with better environmental, social, and good-governance criteria have higher, comparable, or lower average returns than asset allocations that ignore these considerations. A critical question in evaluating ex post performance is whether the differential returns of allocation strategies that include ESG considerations are attributable to ESG factors, or whether measures of ESG ranking are capturing other firm characteristics that are correlated with ESG scores.

In research with several coauthors over the last decade, I have investigated the validity of a number of key premises underlying the sustainable investing proposition. We use in our analysis ESG measures, produced by MSCI KLD, which rank firms based on product, environment, community, diversity, and governance criteria. MSCI is a global provider of equity and fixed income indices and MSCI KLD is one of the most widely used ESG scores by institutional investors and academics. Our analysis focuses on data for S&P 500 firms over the period 1991 through 2009.

Direct versus Selection Effects

A key premise of sustainable investing is that firms "do well by doing good." This implies that a firm's ranking on ESG criteria has a causal effect on its financial performance, for example by lowering its cost of capital. But to what extent do firm sustainability scores simply reflect potential selection effects, whereby successful firms are more likely to be socially responsible for a variety of other reasons ? For instance, firms that have easy access to capital markets might have less leverage in bargaining with labor, and thereby be more likely to fund pensions and have higher ESG scores as a result. In this case, there might be no causal impact of ESG on firms' cost of capital per se, but investors in sustainable companies might inadvertently be exposed to firms with lower costs of capital--those with higher stock...