Some Issues with Using ESG Ratings in an Investment Process

Abstract

A growing number of investors want to integrate information about company sustainability into their investment decision processes to avoid risk, satisfy an asset owner’s needs, or find a new alpha-generating factor. Few new users of environment, social, and governance (ESG) data understand how ESG ratings behave over time. We use the CSRHub data set to show that ESG ratings regress strongly toward the mean. These ratings include both data from most commercial ESG ratings firms and another 640 sources. The observed regression persists within the ratings data across nine years, for a sample set of more than 8,000 companies. Newly-rated companies show even more reversion than “seasoned” companies. It is rare that a company maintains an especially high or low ESG rating. Investors and company managers should both realize that ESG ratings are likely to change toward the mean and that this pattern does not necessarily mean that a good company is getting worse or a bad one is getting better.

TOPICS: ESG investing, portfolio theory, portfolio construction

Key Findings

• • ESG ratings exhibit behavior that may make them difficult to use in an investment process.

• • ESG-based investment strategies that seek to “buy the best and sell the worst” may not perform as well as might be expected.

• • Both investors and corporate managers should adjust their understanding of the significance of ESG ratings and their expectations about how they change.