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The impact of the ESG wave.

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What kind of returns can investors expect compared to traditional investments if they focus on sustainable investments? Would it be "too good to be true" if you can make a good difference and still profit in particular? The answers to this question are diverse - and contradictory.

A fundamental rethink

We are living in turbulent times marked by profound changes. In addition to the century-long challenge of climate change and the dramatic decline in biodiversity, these include social problems that are often linked to increasing income and wealth inequality. A fundamental rethink is therefore more urgent than ever. Investors increasingly want to contribute to this by including ESG criteria in their decisions. The abbreviation stands for ecological (environment), social (social) and corporate (governance) factors that can be applied to investments.

In the introduction to "Mainstreaming Sustainable Investing" [1], Michael J. Greis writes that the purpose of investing is to use capital productively to take advantage of opportunities and overcome challenges - creating value over time for the investors who provide the capital. This value creation occurs in the three systems mentioned above: Environment, Social Life and Corporate Policy. This means that companies are conversely also dependent on the values and resources provided by these systems.

Unsustainable business practices impair these systems, while sustainability maintains or improves them - and is therefore indispensable in the long run. An analogy can be made to what Warren Buffett once said, who called the term "value investing" redundant and simply called it "investing": Ultimately, "sustainable investing" is also simply "investing". In 2018, the then iShares CEO Mark Wiedman put it similarly:

One day we will drop the word 'sustainable' because it will simply be the core of all great portfolios.
Mark Wiedman, Senior Managing Director at BlackRock Inc.

According to Greis, sustainable investors are hardly different from other investors because they strive for the following things: [1]

Reducing risk
Achieving outperformance
Engagement with their investments to improve performance
Achieving economic and/or social goals
Investing in accordance with one's own values and convictions

This list, read from top to bottom, results in the order of preferences of a classical investor. Conversely, the stereotype of the sustainable investor is the reverse, i.e. from bottom to top. The difference therefore lies in the order of preferences.

ESG integration

Sustainable investors see ESG as additional, non-financial information that can be used to broaden and improve the basis for analysis. Therefore, ESG criteria should be integrated into the analysis of companies and stock valuation, instead of acting as external inclusion or exclusion criteria in portfolios. This is the only way to achieve equal or better allocations that ideally have lower volatility - the opposite of the classic "limited opportunities" argument that critics often make. Ideally, the end result could be a "double dividend": Through positive environmental and social impact on the one hand, and financial performance on the other." [3]

But now the question arises: how can companies turn "good" ESG factors into financially measurable performance?

Transmission channels

To this end, the MSCI study "Foundations of ESG Investing, Part 1" presents three transmission channels: [4]

Cash flow channel: Companies with high ESG ratings are more competitive and can generate above-average returns on their investments. This allows for higher profitability and higher dividends.
Risk channel: Companies with high ESG ratings are better able to manage their business risks, which reduces the likelihood of negative incidents. This means lower tail risks.
Valuation channel: High ESG-rated companies are less exposed to systematic risk factors. Accordingly, their risk premiums and expected cost of capital are lower, justifying higher valuations.
impact of esg wave_transmission channels
Figure 1) Transmission Channels [4]
Source: Giese, G. / Lee, L.-E. / Melas, D. / Nagy, Z./ Nishikawa, L. (2017), Foundations of ESG Investing, Part 1: How ESG AffectsEquity Valuation, Risk and Performance.

According to the study, the translation of ESG factors into financial values is a multi-channel process. While these effects are not too strong, they tend to last for several years. This makes sustainable investing particularly interesting for investors with a long-term investment horizon.

The authors found empirical evidence that there is a causal relationship between ESG and financial ratios. According to this, the change in ESG rating can be used as an indicator (ESG momentum): rapid, significant improvements in ratings should represent the best time to invest, even before the market fully prices them in. This can be pushed by advocacy groups such as the Principles for Responsible Investment, which already have more than 3000 signatories and manage or own more than $100 trillion in assets.

impact of esg wave_virtuous circle
Figure 2) The Virtuous Circle [14]
Source: Cornell, B. / Damodaran, A. (2020), Valuing ESG: Doing Good or Sounding Good?, p. 6

The ESG wave

BlackRock predicted back in 2018 that assets under management in ESG ETFs would grow from 25 billion US dollars at the time to 400 billion US dollars in 2028. Accordingly, a new era has begun in which the question is no longer "Why invest sustainably?" but "Why not?" [5]

The study "Is ESG a Factor?" also goes in this direction. The authors point out that new capital owners - especially women and millennials - will prioritise ESG in their portfolios over the next two decades. [6] The "ESG wave" could permanently shift the preferences of many investors.

MSCI's "Swipe to Invest" paper confirms this: according to a 2019 survey of high-net-worth investors by the Morgan Stanley Institute for Sustainable Investing, 95 per cent of Millennials are interested in sustainable investments. This highlights the desire not only to generate returns, but also to invest in line with personal values and contribute to social good. Crucially, Millennials born between 1981 and 1996 represent around 80 million people in the US alone who will inherit a significant amount of wealth in the future.

"We are in the midst of a $30 trillion transfer of wealth from the baby boomer generation to their children"
(Dave Nadig, [7].

Institutional investors have long been riding the wave as well. Billions of euros and dollars have been invested in technologies and industries that should benefit from the transition to a clean energy world. One could call climate change, viewed positively, the growth story of the current generation. And the associated, politically driven climate investments have the potential to trigger a reassessment of markets.

However, in the whole discussion, it is important to distinguish what exactly studies have looked at: Corporate-level impacts or investment portfolio outcomes. This can make a big difference, as the seminal meta-study "ESG and Financial Performance: Aggregated Evidence from More than 2000 Empirical Studies" showed in 2015. [8]

The (difficult) question of returns

The influential paper evaluated the results of around 2200 individual studies. In around 90 percent of the individual studies, the researchers found a non-negative correlation between ESG criteria and the financial performance of the companies. But did this also benefit investors? Here the study also comes to positive results, but these are less clear, as the following chart shows. The "portfolio studies" marked in light grey are decisive.

esg influence on returns
Figure 3) ESG influence on Returns
Source: Friede, G. / Busch, T. / Bassen, A. (2015), ESG and Financial Performance: Aggregated Evidence from More than 2000 Empirical Studies, Journal of Sustainable Finance & Investment, Vol. 5, No. 4, p. 221

In the emerging markets, the positive ESG effect was particularly pronounced. [8] This is probably mainly due to sustainable corporate policies, which are also frequently associated with positive returns in practice. Since corporate governance standards in emerging markets are often significantly lower than in industrialised countries, voluntary commitments provide a correspondingly positive effect on investment risk - management acts more reliably in the interest of shareholders.


However, there are various arguments against the outperformance of sustainable investments. For instance, the high discrepancy of available ESG data sources so far hardly allows for clear results that can consolidate a consensus. Moreover, quite a few individual studies have found mixed and partly negative results. If one assumes higher fees for sustainable investments overall, resulting from additional costs for ratings and personnel for data evaluation, one quickly ends up with potential underperformance. Even the otherwise rather positive meta-study does not rule out this possibility:

"Investors, on average, are unlikely to harvest the existing ESG alpha after implementation costs."

The authors of the Credit Suisse Global Investment Returns Yearbook 2020 also tend in this direction, stating that despite extensive literature, almost no convincing studies can be found that show that ESG funds perform better in the long term. There is also the question of causality: it is impossible to say whether companies that do good therefore perform well - or whether companies that perform well do good for that reason. Last but not least, there is a classic backtesting problem with ESG indices: Whenever the index history included backtesting before the official launch, the backtest performance has been higher than the post-launch returns. [9]

Research Affiliates is also rather sceptical. According to them, alleged ESG return premiums have not yet been confirmed by long and thorough academic studies. Moreover, the results are not robust to different ESG definitions and different regions. [6]

The study situation is currently completely unclear on the topic of CO2 emissions. Researchers disagree on whether or how a company's carbon emissions affect stock performance. And this despite the fact that some of the studies use the same data.

Too good to be true?

Various factors influencing the performance of investment portfolios can be distinguished. These include, above all, risk-related variables such as country, sector and factor exposures. The actual drivers of apparent ESG outperformance (or underperformance) are in fact often of a structural nature: classic fundamentals, growth expectations and intangible assets determine performance.

This became particularly clear in the study "ESG Didn't Immunize Stocks Against the COVID-19 Market Crash": an analysis of more than 1600 US stocks showed that ESG scores contributed on average only one percent to explaining returns in the first quarter of 2020, and only up to three percent in the second quarter. [10]

Figure 4) Explanatory Factors in Q2 2020 [10]
Source: Demers, E. / Hendrikse, J. / Joos, P. / Lev, B. (2020), ESG Didn't Immunize Stocks Against the COVID-19 Market Crash, p. 32

Contrary to what is often claimed, ESG ratings hardly played a role in the returns achieved. This is also confirmed by the article "ESG Investing: Too Good to Be True? According to the article, the (temporarily) above-average performance of sustainable stocks was partly due to an underweighting of weak value stocks and an overweighting of well-performing technology stocks. However, this could also look quite different in the future. According to the author, it would be "too good to be true" that ESG shares generally perform better. [11]

The study "Sin Stocks Revisited" also sees factor exposures as a key driver. Depending on whether sin stocks are concentrated in factors with positive premiums or not, they have higher or lower returns than the market average. According to the authors, however, expected returns can be maintained even when sin stocks are excluded. And this is done by weighting ESG portfolios in such a way that the original factor exposures do not change. [12]

Another point against ESG criteria is that they are snapshots. The "sinners" in particular could be open to change or already be pursuing concrete steps for improvement, but these are not yet reflected in the ratings. One would therefore miss out here on participation in the "ESG turnaround", which could be accompanied by particularly positive returns. [12]

Theoretically negative

Finally, the classic counter-argument to ESG investments is when the factors are not considered in an integrated way, but simply "bad" stocks are excluded from the portfolio: Returns cannot be increased for a given risk by limiting the options. Quite the opposite: if the sin stocks are systematically avoided, this should lead to higher expected returns on these stocks in the market, all other things being equal. This in turn would have an interesting effect, as Cliff Asness described in an article: the higher expected returns of the "bad" stocks are (theoretically) at the same time the cost of capital of the investment projects of these companies. This means that their hurdle rate is higher than that of sustainable companies, so that more of these projects are imputedly unprofitable - and accordingly fewer of them are implemented. This would then be precisely the positive change that sustainable investing strives for. [13]

That sin stocks can perform excellently is shown by historical data: From 1926 to 2006, US stocks in alcohol, tobacco, gambling and guns outperformed by three to four percent per year. [9] At the same time, however, they also presented particular risks in terms of regulations, requirements and prohibitions or waves of lawsuits.

impact of esg wave_sin stocks
Figure 5) Sin Stocks [9]
Source: Dimson, E. / Marsh, P. / Staunton, M. (2020), ESG Investing, in: Credit Suisse Global Investment Returns Yearbook 2020 - Summary Edition, Research Institute, p. 9

Excluding these stocks therefore meant clear underperformance. However, this need not apply equally to the future: If a fundamental change is brought about as a result of which the majority of people think sustainably when making consumption decisions and thus directly influence the economic basis of companies via an actual shift in demand, the historical outperformance of "sin stocks" could remain just that - a return effect of the past.

Other effects are also conceivable here. For example, that the best talent applies to sustainable companies, giving them a permanent competitive advantage with less staff turnover. Or that sustainable companies can recruit better and more reliable partners and suppliers. [14]

Market arithmetic

So the market arithmetic "problem" is that all stocks must always be owned by someone. Investors who do not pay attention to ESG criteria therefore have somewhat greater pricing power with the relevant shares: they can demand higher returns as an incentive to hold sin stocks, a kind of "reputation premium". This was already pointed out in the previously mentioned study "Sin Stocks Revisited: Resolving the Sin Stock Anomaly". The authors go on to write that the criteria for sin stocks can shift due to a change in social norms. For example, companies such as Coca-Cola and McDonald's may one day be considered sin stocks if sugar and fat are targeted because of increasing obesity and related diseases. [12]

However, many advocates of sustainable investments criticise the adoption of this whole consideration. The main argument: simply excluding certain stocks is only the easiest (and worst) way to invest sustainably. There have long been better approaches such as best-in-class, ESG integration and thematic approaches. These are not subject to the theoretical assumptions of the exclusion model, so that no impairment of the efficiency line according to classical portfolio theory has to result from this or even an improvement would be possible.

esg efficiency line
Figure 6) ESG efficiency line
Source: Pedersen, L. H. / Fitzgibbons, S. / Pomorski, L. (2019), Responsible Investing: The ESG Efficient Frontier, p. 3.

Between the two camps, there is a third possibility: sustainable investments could temporarily outperform due to political pressure and high attention. This can be explained in models by a surprising increase in ESG preferences among investors, who all jump on the new trend. The point here would be to be in as early as possible to profit from the wave - but this point in time could already be over. Then the focus could shift back to risks in the future and thus weigh on returns. For example, the assessment that companies with an ESG focus feel more obliged to their stakeholders than to their shareholders: Resources that should flow to shareholders via dividends or share buybacks could be used elsewhere. [15]

Ultimately, putting more resources into ESG analysis could even be detrimental to market efficiency. Especially if this is at the expense of important, classic fundamentals. The consequence would be that the market overreacts to negative ESG news with price losses, as the authors of the study "Stock Price Overreaction to ESG Controversies" write. Conversely, negative fundamental news could be wrongly "forgiven" for companies with a high ESG rating. In turn, anti-cyclical investors who do not pay attention to ESG criteria could benefit from these mispricings in a similar way to sin stocks. [16]


Sustainable investments are basically a "good" idea. However, it is and remains controversial how ESG criteria affect returns. Ultimately, sustainable investments could be subject to a cycle of outperformance and underperformance over time. In that case, there would be no significant difference in returns over the long term. Or markets become more efficient and price ESG information faster and better, so the performance question becomes moot on its own. At the same time, investors with ESG investments could hold out longer because they see a real sense in it - and therefore do not sell when there is panic in the market, as is the case with other funds. In this way, too, they could ultimately perform better. And who knows - maybe convinced ESG investors really don't look at returns and the preservation of their purchasing power is enough for them if they know they are doing something good with their money.

But to really drive real change, sustainable investors also need to become active themselves instead of just redistributing funds. After all, not every company is dependent on equity financing. That is why professional impact investors collectively lobby companies in which they are invested for their interests and goals.

Private investors should also not underestimate their collective role and their influence on fundamental developments. Living sustainability and striving to do the right thing in one's own consumption decisions can bring about significant changes in the long run - changes that translate from the real world to the markets, and not the other way around. Perhaps the topic of ESG will bring the attention necessary for this to happen, awakening the potential of such a wave.

[1] Greis, M. J. (2018), Mainstreaming Sustainable Investing, CFA Institute Research Foundation
[2] Financial Times (2018), BlackRock stakes claim on ‘sustainable investing’ revolution,, Zugriff am 24.01.2021
[3] altii (2018), Mehrwert durch „ESG Momentum“, Interview mit Michael Huber, Raiffeisen Capital Management, S. 2
[4] Giese, G. / Lee, L.-E. / Melas, D. / Nagy, Z. / Nishikawa, L. (2017), Foundations of ESG Investing, Part 1: How ESG Affects Equity Valuation, Risk and Performance
[5] McGrath, J. (2018), BlackRock predicts ESG ETF growth to $400bn, ESG Clarity,, Zugriff am 24.01.2021
[6] West, J. / Polychronopoulos, A. (2020), Is ESG a Factor?, Research Affiliates
[7] MSCI (2020), Swipe to Invest: The Story Behind Millennials and ESG Investing, MSCI ESG Research
[8] Friede, G. / Busch, T. / Bassen, A. (2015), ESG and Financial Performance: Aggregated Evidence from More than 2000 Empirical Studies, Journal of Sustainable Finance & Investment, Vol. 5, Nr. 4, S. 210-233
[9] Dimson, E. / Marsh, P. / Staunton, M. (2020), ESG Investing, in: Credit Suisse Global Investment Returns Yearbook 2020 – Summary Edition, Research Institute, S. 7-17
[10] Demers, E. / Hendrikse, J. / Joos, P. / Lev, B. (2020), ESG Didn’t Immunize Stocks Against the COVID-19 Market Crash, NYU Stern School of Business, S. 32
[11] Rabener, N. (2019), ESG Investing: Too Good to Be True?,, Zugriff am 24.01.2021
[12] David Blitz and Frank J. Fabozzi (2017), Sin Stocks Revisited: Resolving the Sin Stock Anomaly, Journal of Portfolio Management, Vol. 44, Nr. 1
[13] Asness, C. (2017), Virtue is its Own Reward: Or, One Man’s Ceiling is Another Man’s Floor, Cliff's Perspective, AQR Capital
[14] Cornell, B. / Damodaran, A. (2020), Valuing ESG: Doing Good or Sounding Good?
[15] Rabener, N. (2019), Why Pension Funds and Millennials Should Avoid ESG, in: Beyond Beta Q4 2019, S. 18-21
[16] Cui, B. / Docherty , P. (2020), Stock Price Overreaction to ESG Controversies
[17] L. H. / Fitzgibbons, S. / Pomorski, L. (2019), Responsible Investing: The ESG Efficient Frontier, p. 3.

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