Are ‘noisy’ ESG ratings that useful?

Research suggests method to wring excess returns out of contentious criteria

Are ‘noisy’ ESG ratings that useful?

Many investors in the ESG sector are dissatisfied with the uneven criteria used by index providers. Yet recent research by the MIT Sloan School of Management offers a potential remedy that, it claims, also increases returns.

The report looked at MSCI, S&P Global, ISS, Moody's ESG Solutions, Reprisk, and TruValue Laboratories as the six index providers. When the six indexes were combined, they generated excess returns of 6% in the United States and Europe and 9.6% in Japan.

The simplest aggregation strategy, which gives each ESG index identical weight, produced an excess return of 7.7% in the United States when used with a portfolio that is long the companies in the top quartile of ESG ratings and short the stocks in the worst quartile.

With the anti-woke movement gathering momentum, the argument over whether sound ESG norms are linked to profitable business outcomes has become more heated. Empirical data on the extra returns produced by ESG investment has been inconsistent, with some studies finding a negative link and others claiming a positive one.

According to MSCI, arguably the most well-known index provider, a portfolio that invests in stocks that score in the top quartile on ESG factors and shorts the stocks that score in the lowest quartile between 2014 and 2020 generated an excess return of 3.8% annually. Yet, a comparable portfolio using the S&P Global rating methodology only generated an extra return of 0.31 percent annually.

“The choice of different data methodologies and sources can lead to a substantial divergence between rating providers,” the paper said. “This raises the question [of] whether ESG ratings are in fact useful for portfolio construction, and if so, how to optimally exploit the signal in ESG ratings, despite their noisy nature.”

Investors may lower the noise level of each supplier, the report argues, by aggregating ESG ratings from several sources. When aggregating techniques are applied, ESG returns are consequently significantly greater.

“Diversifying the source of ESG ratings is very helpful,” Florian Berg, research scientist at MIT Sloan School of Management and one of the paper’s five authors, said. “Having more than one source...[helps] you get rid of some noise.”