ESG – another bubble waiting to happen?

From 17th Century tulip mania to the Dotcom bubble of the 1990s, asset bubbles are a recurrent economic feature, and the question as to whether ESG is “another bubble waiting to happen?” was recently posted on the EBI forum.

To help us respond to this question two ESG industry experts Sam Adams, CEO of Vert Asset Management and a Non-Executive Director at EBI, and Garret Quigley, Managing Partner and  Co-CIO of GSI have been asked for their thoughts.

Sam Adams

The question about an ESG bubble is being asked more often, as flows to ESG funds continue to rise. The trouble with the bubble thesis is this, however.  There is no broad consensus on which stocks are ‘ESG’. So, all this money flowing into ESG, isn’t flowing into a narrow set of companies, like with the Nifty Fifty, or tech stocks, or BRICs.

The academic research paper, ‘Aggregate Confusion: The Divergence of ESG Ratings’ [1]shows an abundance of statistics on how ESG researchers like MSCI and Sustainalytics only agree about half the time.  Many of the biggest funds and ETFs use one or another of these ratings services to select securities.

The post references an FT article which quite neatly outlines the debate around performance of ESG.  It’s either going to outperform as prices adjust to surprises, carbon pricing, the new reality of climate change, etc.  Or it’s going to underperform because High ESG firms will have higher prices and thus lower costs of capital.  Curiously, the FT author left out a big piece which is risk.  A high ESG firm with lower cost of capital might have lower future returns…but that’s because it will have lower risk.

But at the end of the day, we don’t know. ESG is 15 years old. We don’t have enough data history to definitively say whether ESG will outperform or not, or whether this is a bubble or not.  We just don’t have enough evidence.  So we are uncertain.

Garrett Quigley

In relation to the comment on ESG stocks being in a bubble, in general, I don’t think it’s right to say that ESG stocks are in “bubble” territory, but it might be worth looking at a core ESG index vs its benchmark and comparing valuations.

For our own fund (Global Sustainable Focused Value), since we explicitly control for valuation in portfolio construction, our fund exhibits far deeper value characteristics than the core benchmark, whilst at the same time having a better ESG score. So there is no risk of our holdings being exposed to any bubble pricing.

I think some of the points referenced in the FT article are worthwhile, but the core premise is not valid – that you can’t have an ESG portfolio without having lower expected returns. A very similar academic line of argument was made in 2009 in a paper called ‘The Price of Sin: The Effects of Social Norms on Markets [2]’. The general argument was that because Sin stocks are undesirable, their prices get pushed down reflecting the lower demand, and so their expected returns ought to be higher. In fact a later paper ‘Sin Stocks Revisited: Resolving the Sin Stock Anomaly [3]’ blew this apart by showing that their results didn’t take into consideration the additional factors in the Fama-French 5-factor model. Blitz and Fabozzi corrected for that and showed that there is no Sin Stock effect at all. Sin stocks just invest less and are more profitable, but so are other non-sin stocks which also have higher returns.

More generally, MSCI do not seem to control for sector or industry when they form their ESG scores. So there are very big industry differences between their high vs. low ESG stock groups. This then shows up in the returns. But much of the recent difference between these two groups is due to Covid, and only indirectly due to ESG – i.e. Tech companies benefitted with the move to online commerce and work; oil companies, airlines etc. got bashed because we stopped travelling. So the main reason for the difference in stock returns isn’t due to ESG so much as exposure to the economic cycle, technology changes etc.

Sustainalytics (the primary provider of ESG data to GSI) take industry differences into account when they assess companies on ESG so their high ESG stocks should not exhibit such big industry differences with the low ESG group. We also explicitly control for valuation exposure in the portfolio so we will protect against inflated prices of high ESG stocks, if there is any.

EBI’s perspective

Sam’s point on the definition of ESG stocks and breadth of companies receiving these investments is a useful one to communicate, when faced with the ‘bubble’ question.  At EBI, we have circa 7,000 equities in its Earth portfolios, avoiding the concentration of a few hundred stocks that most would expect to see in an ESG portfolio. Diversification mitigates risk.     

Garrett’s point that that expected returns are driven by factor exposures and that GSI model the ESG exposure separately is an important one. The latter should not impact the overall factor exposure in the portfolio, or the targeted expected return.

ESG is only 15 years old and an academic consensus is yet to be reached, but what is beyond doubt is that ESG funds continue to grow, driven by investor demand and public demand.

In his recent EBI ESG webinar, Chairman of Arabesque,  Georg Kell highlights that the Covid-19 pandemic has acted as an ESG accelerator, and that as a trend, it is “transformative and irreversible.” 

In his recent EBI ESG webinar, Chairman of Arabesque,  Georg Kell highlights that the Covid-19 pandemic has acted as an ESG accelerator, and that as a trend, it is “transformative and irreversible.” 

View Georg Kell’s Webinar on ‘Decarbonisation, Digitalization and Sustainability’ here.

EBI are currently running a series of ESG webinars titled the ‘Summer of Sustainability’ with industry experts Sam Adams, Garrett Quigley, and Julia Kochetygova.

EBI’s ESG webinars

[1] Berg, Florian and Kölbel, Julian and Rigobon, Roberto, Aggregate Confusion: The Divergence of ESG Ratings (May 17, 2020). Available at SSRN

[2] Kacperczyk, Marcin T. and Hong, Harrison G., The Price of Sin: The Effects of Social Norms on Markets (March 15, 2006). Sauder School of Business Working Paper, AFA 2008 New Orleans Meetings Paper, EFA 2006 Zurich Meetings, Available at SSRN

[3] Blitz, David and Fabozzi, Frank J., Sin Stocks Revisited: Resolving the Sin Stock Anomaly (August 9, 2017). Journal of Portfolio Management, Vol. 44, No. 1, 2017, Available at SSRN