November 1, 2019

ESG Schizophrenia..........How To Cure It

“Schizophrenia is a mental illness characterized by abnormal behavior, strange speech, and a decreased ability to understand reality. Other symptoms may include false beliefs, unclear and confused thinking, and hearing voices that do not exist….”



“Despite its follies, foibles, and fashions, the stock market is a good deal more rational than the ‘experts’ over any extended period of time.”

Peter Drucker


ESG Schizophrenia

The New York CFA Society recently surveyed a large sample of asset owners on their attitudes towards, and feelings about ESG. Forty five percent responded that their organization had fully, or significantly integrated ESG across their portfolios. Another 39% said they were on their way to doing so. At the same time, the respondents confessed to having an ESG worry list which included data quality problems, terminology confusion, political and regulatory uncertainty, greenwashing, and scepticism about the validity of the ESG concept itself.i    

A recent academic paper titled “Aggregate Confusion: The Divergence of ESG Ratings” provides empirical justification for the ESG worry list. Based on a detailed assessment of the ESG ratings from five different agencies, the authors found material divergences between the five rating sets due to what the paper called ‘scope divergence’, ‘measurement divergence’, and ‘rater effect’. Scope relates to decisions of what factors should be included in the definition of ESG, measurement relates to decisions on what metrics best represent each of these factors, and rater effect is the apparent tendency of some agencies to like and  dislike certain companies (i.e., represented by systematic upward and downward biases in how the components of the ESG rating were scored and assembled). The authors conclude that this diversity in ESG ratings leads to material diffusion of their impacts on asset pricing, on signals to corporations, and on research conclusions.ii

Where does all this leave asset owners? Are ESG ratings useful? Are some more useful than others? Do they help control investment risk? Enhance investment return? Both? Neither? These are the questions this Letter addresses.

From ‘Means’ to ‘Ends’

A good place to start is to distinguish between means and ends. Last month’s Letter offered a 5-dimensional taxonomy for ‘finance’ (i.e., primary investing, secondary investing, price discovery/liquidity, risk mitigation, and financial infrastructure). It also explored the implications of placing ‘sustainable’ in front of each of the five dimensions, where ‘sustainable’ means adaptable/ongoing through time at both micro (organizational) and macro (biosphere/humanity) levels. These definitions led to the following ‘end’ statement for ‘sustainable secondary investing’:

“Investing sustainably in outstanding issuer stocks and bonds in public and private markets has become the most visible face of sustainable finance. The movement towards ‘ESG’ investing is only part of the story. A credible transformation to sustainable investing by investment institutions involves board buy-in, specialist staffing, redesigned financial incentives, financial and climate risk modeling capabilities, redesigned performance benchmarks, and a ‘minimum sustainability threshold test’ for eligible investments. The focus of this test is the sustainability of the entities that are investment candidates for the investment institution. The test logically links micro sustainability at the organizational level to macro sustainability at the biosphere/humanity level. Once again, the specifics of such tests will not be without controversy. On the positive side, the UN’s 17 Sustainable Development Goals (SDGs) offer guidance for how a ‘minimum sustainability threshold test’ for investee organizations might be designed.” 

The point should be clear. At the micro level, the ESG dimension in sustainable investing is only a means to an end, with the end being to reliably generate expected rates of return over long periods of time. But does ESG investing carry a cost in terms of potential returns foregone? Let’s see if academic research can answer this question.

Characteristics of High-Return Portfolios   

What are the characteristics of portfolios that generate high returns over extended investment periods? Consider the findings of the five studies summarized below. 

  • Cremers and Pareek (CP)iii: found that investment managers with low portfolio turnover and concentrated positions outperformed managers without these two combined characteristics by a statistically-significant 2.3%/yr. over 20+-year observation periods. The authors noted that portfolios lacking these two combined features produced, on average, index-like performance or worse.
  • Harford, Kecskes, and Mansi (HKM)iv: found that investment managers with low portfolio turnover and concentrated positions were disproportionately invested in a subset of companies that had relatively higher-quality boards, higher proportions of shareowner proposals, more innovation, higher returns on capital, and higher dividend payouts. These companies also had relatively lower take-over defenses, lower incidence of managerial misbehavior, lower financial leverage, and lower volatility of sales, costs, and earnings. The subset of low turnover/high concentration managers outperformed the rest of the manager universe by a statistically significant 3.5%/yr. over 20+year observation periods.
  • Khan, Serafeim, and Yoon (KSY)v: found that portfolios made up of companies with high KLDvi sustainability scores weighted by SASBvii materiality scores outperformed portfolios of companies with low KLD sustainability scores weighted by SASB materiality scores by average annual return gaps ranging from 3.1%/yr. to 8.9%/yr. over 20+year observation periods, depending on the degree of portfolio concentration.viii They observed their results were notably different from the mixed results of previous ESG studies that did not include the materiality dimension.
  • Barton, Manyika, Koller, Palter, Godsall, and Zofferix: used consulting firm McKinsey&Co’s 5-factor Corporate Horizon Index (CHI) to rank a list of 615 corporations by the degree to which their behaviors favored long-termism over short-termism. Using McKinsey’s own databases, the five ranked factors were Investment, Innovation, Earnings Quality, Margin Growth, and Earnings Growth. Corporations with high CHI rankings materially outperforming low-ranking corporations based on revenue growth, earnings growth, R&D growth, and total return to shareholders (TRS) over the course of the last 15 years.
  • Crosby, Roffman, and Tangx: used the Drucker Institute Corporate Effectiveness Rankings to create a Top100 Drucker Index out of the 500 companies in the S&P500. These rankings are based on the Drucker philosophy that effective corporations “do the right things well”. Specifically, the rankings are based on five factors: 1. Customer satisfaction, 2. Employee engagement and development, 3. Innovation, 4. Social responsibility, and 5. Financial strength. A key ranking criterion is consistency across all five factors. The Drucker100 outperformed the S&P500 by 2.5%/yr. for the five years ending September 30, 2019 (13.3% vs. 10.8%). 

What should we make of the findings in these studies?

Lessons Learned

Inductively, CP discovered portfolios that combined high concentration and low turnover had materially higher average long-term investment returns than portfolios without these two characteristics. HKM went further by finding that low turnover, high concentration investors favored companies with high scores on governance quality, shareowner proposals, innovation, return on capital, and dividend payouts, and low scores on take-over defenses, incidence of managerial misbehavior, financial leverage, and volatility of sales, costs, and earnings. These findings are consistent with the premise that low-turnover, high-concentration investors are likely also ‘active ownership’ investors.

Deductively, the KSY, McKinsey, and Drucker Institute studies start with the logic that some corporate behaviors are consistent with shareholder value-creation, while others are not. As value-creation proxies, KSY use the KLD corporate sustainability ranking protocol that started in 1988. Their innovation was to weight the KLD scores with SASB’s corporate materiality scores. The McKinsey and Drucker Institute teams used their own databases to create rankings of the quality of corporate value-creation decisions and public disclosure protocols. In the end, all three value-creation proxy models were able to distinguish between high- and low-value creating investments over extended time periods, and that distinction in turn led to the generation of positive excess returns.

The inductively and deductively-derived research findings are mutually supportive. The former discover exceptional investment results and identify ‘value-creation’ drivers supporting it. The latter use logic to identify the key drivers of corporate value-creation, and discover that portfolios that embody these drivers do indeed experience exceptional investment results.xi

A Cure for ESG Schizophrenia

Given all the above, is there a cure for ESG schizophrenia? Yes there is. Here is a 3-step remedy:

  1. Accept the fact that ‘ESG Investing’ is too broad a term to be operationally-useful.
  2. Accept the fact that at a micro level ‘value-creating investing’ means full immersion into Peter Drucker’s world of assessing which companies “are doing the right things well”…or could do the right things well with some asset owner persuasion. To repeat, full immersion means board buy-in, specialist staffing, redesigning financial incentives, financial and climate risk modeling capabilities, redesigning performance benchmarks, and establishing a ‘minimum sustainability threshold test’ for eligible investments.
  3. Accept the fact that at a macro level asset owners have a collective responsibility to play a constructive role in ensuring that their members/beneficiaries/clients continue to live on a planet which is physically and socially sustainable. There are plenty of collective initiatives through which this responsibility can be fulfilled. Get involved!

Are you ready to take the cure?

Keith Ambachtsheer



  1. Reported by P&I in an October 2019 article “Asset owners allocate more to ESG”.
  2. See Florian Berg, Julian Kolbel, and Roberto Rigobon, MIT Research Paper, posted on SSRN, August 2019.
  3. See Martijn Cremers and Ankur Pareek. 2016. “Patient Capital Outperformance: The Investment Skills of High  Active-Share Managers who Trade Infrequently”, Journal of Financial Economics
  4. See Jarrod Harford, Ambrus Kecskes, and Sattar Mansi. 2015. “Do Long-Term Investors Improve Corporate Decision-Making?” Working Paper.
  5. See Mozaffar Khan, George Serafeim, and Aaron Yoon. 2016. “Corporate Sustainability: First Evidence of Materiality”. The Accounting Review.
  6. Originally founded as Kinder, Lydenberg & Domini Research Analytics in 1989, KLD is now a division of MSCI.
  7. The Sustainable Accounting Standards Board (SASB) was founded in 2011 to foster more complete disclosures regarding the impact of environmental, social, and governance factors on corporate affairs.
  8. KLD creates its sustainability scores based on four considerations: Environment, Community/Society, Employees/Supply Chains, and Governance/Ethics. SASB corporate ESG materiality scores are based on the relative frequency of keyword mention of 43 generic sustainability factors.
  9. See Dominic Barton, James Manyika, Tim Koller, Robert Palter, Jonathan Godsall, and Josh Zoffer. 2017. “Measuring the Economic Impact of Short-termism”, McKinsey Global Institute, Discussion Paper. The results were discussed in an article in the February 2017 issue of the Harvard Business Review “Finally, Evidence that Managing for the Long-Term Pays Off”, by Dominic Barton, James Manyika, and Sarah Williamson.
  10. See the October 2019 article “Making Intangibles Tangible”, published by the Drucker Institute.
  11. All this raises the state of academic research on these issues. It is telling that in a 2008 Journal of Banking and Finance article titled “Socially Responsible Investments: Institutional Aspects, Performance, and Investor Behavior” authors Renneboog, Ter Horst, and Chang wrote: “Existing studies on Socially Responsible Investing hint, but do not unequivocally demonstrate that SRI investors are willing to accept suboptimal performance to pursue social or ethical objectives. However, the emergence of SRI raises interesting questions for research on corporate finance, asset pricing, and financial intermediation.” The five cited large database studies published in the 2015-2019 period show how far answering these questions has come.  


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