The claim that impact investing does “not entail a reduction in financial returns” is inconsistent with two other claims in the report. The first is that good ESG practices reduce a company’s cost of capital. The company’s cost of capital is its weighted cost of equity and debt (stocks and bonds). To put it another way, the company’s cost of capital is the same as the investors expected return. If a company’s cost of capital is lowered, then the ex-ante returns that an investor receives will be lower.
The second inconsistent claim is that divestment has been successful in providing managers an incentive to adopt good ESG practices. In fact, if companies with strong ESG bonafides provide a superior ex-ante return, then the corporation would have an incentive not to adopt ESG policies. It is only when ESG provides lower ex-ante return to investors that corporations will have an incentive to adopt these policies.
These points are explained in more clarity and depth by Cliff Asness here: https://www.aqr.com/Insights/Perspectives/Virtue-is-its-Own-Reward-Or-One-Mans-Ceiling-is-Another-Mans-Floor
The same logic also naturally applies to ESG funds. If a manager is known to outperform because of their superior use of ESG information then, on average, you can expect their fees to rise to reflect this and to neutralize the benefits to incoming investors to the fund.
I don’t know if this is necessarily true, because often times outperforming firms get inflows of assets. Then they wouldn’t have to raise their fees because they make more money by taking the same (or lower) fees off of a larger pool of assets.
There may be research out there that completely disproves my hypothesis, it is just a hypothesis, but I don’t think one can necessarily make that logical jump.
Thanks for the comment! I don’t fully understand the point you’re making in the second paragraph, do you mind expanding a bit?
On your first p0int, you would be correct assuming efficient markets and that all information is priced in. A lot of ESG research has been making the claim that ESG factors are material, and often ignored by mainstream managers (not priced in). This could lead to the result you describe.
I could understand that you may be skeptical of ESG being material and not priced in. I will say that discussion of ESG factors is showing up in more and more mainstream investment managers reports in the context of “just good business”, indicating that investment managers are starting to look more at ESG factors as material.
Thanks for the reply and sorry for the delay. I can see how my second point was unclear. Let me reframe it by saying that the evidence does not support that impact investing has been, in the past, effective at providing corporations an incentive to adopt ESG. The evidence that ESG factors produced above market returns is evidence that fund flows did not raise the price of ESG factors, thus provided no incentive for corporations to adopt ESG (above whatever profit maximization incentives already existed).
On the first point, you are arguing that ESG is not priced into current prices, and that ESG factors will produce higher returns in the future. I guess I disagree. I know there are a few factors that have long track records of overperformance (value, momentum, low vol). I do not think there is sufficient evidence to claim that ESG is a similar factor. It just seams like conjecture at this point. I would say I believe in weak-form efficient market hypothesis. Basically you can get above-market returns, but it is a lot of work, and simple theories are unlikely to work.