Many investors seek out stocks with high ratings on environmental, social, and governance (ESG) factors to align their investments with their ethics. However, there is another compelling argument for shifting to an ESG-weighted portfolio: A stock’s ESG rating may be a useful gauge of its future risk profile.
What ESG Says about Risk (and Return)
AQR Capital Management, an asset manager specializing in alternative investment strategies, performed an in-depth comparison of ESG stocks, comparing their relative risk profiles versus those of stocks with low ESG ratings. It concluded that “ESG exposures may be informative about the risks of individual firms,” suggesting that a firm’s ESG rating could be used in portfolio selection to help choose less-risky stocks.
While some level of risk is inherent in investing, the effects of unsystematic risk (i.e., risk specific to a certain company) can lead to negative portfolio performance. According to the AQR report, “Stocks with the worst ESG exposures have total and stock-specific volatility that is up to 10–15% higher.” It also noted that a stock’s beta—a measure of how much it deviates from the overall market’s volatility—can be 3% higher for equities with poor ESG records.
It makes sense that firms with poor ESG ratings often have a higher risk profile. Consider a company that has a poor ESG rating because it treats its employees badly. That governance shortcoming, reflected in the company’s ESG score, raises the likelihood that sometime in the future the company will be hit by a strike or boycott, creating significant risk for its investors.
In a real-life example, German carmaker Volkswagen’s ESG rating dropped precipitously in 2013, two years before the company became embroiled in an emissions cheating scandal. Why had the company’s ESG rating been lowered? For governance reasons: VW had too few independent directors on its board. And many analysts have put blame for the scandal squarely on the shoulders of poor corporate governance.
In addition to market risk for equities, investors are also increasingly using ESG data to better focus on a company’s credit risk or likelihood of default, an important consideration for pension funds. Such risk might be limited to one company or represented across an entire industry. Utilities, for example, are more exposed to environmental risks than are financial companies.
AQR doesn’t make the case that the risk differences are staggering. On average, companies might experience a 1% increase in risk. But for investors buying stocks, knowing which equities present greater risks is actionable information. Additionally, certain risks may seem smaller than they are, as there are difficulties associated with projecting long-term risk and certain risks (e.g. pollutive emissions) take time to accumulate.
The Current State of ESG Risk Data
Interestingly, AQR found that social and governance issues more closely reflect a stock’s future riskiness than do environmental issues. AQR suggested that while environmental factors may simply be less predictive of risk, it could also be that environmental exposure data is “noisier” than that of social and governance factors, meaning that it contains unexplained variations that undermine the calculation of “more precise, statistically significant estimates.”
In this case, as AQR suggests, “ESG exposures may convey information about future risks that are not captured by statistical risk models.” Statistical risk uses things like a correlation coefficient to arrive at how much a stock correlates with an index. But other risks are difficult to calculate this way. As ESG data improves, calculations may become more precise. But only time will tell.
It’s abundantly clear that ESG factors can affect a firm’s or an industry’s risk to some useful extent. Sometimes there are several ESG factors that must be carefully weighed before an investment is made.
“ESG information may play a role in investment portfolios that goes beyond the ethical considerations and may inform investors about the riskiness of the securities in a way that is complementary to what is captured by tradition statistical risk models,” AQR said.