ESG-informed investing does not lead to positive sustainability: Scientific Beta

New research highlights that rigorous frameworks are necessary for evaluating environment, social, and governance (ESG) investment potential, while adding that not all ESG-informed investments will translate into a positive sustainable outcome.

The Scientific Beta Does ESG Information Deliver Investment Value? A High-Dimensional Portfolio Perspective report employed out-of-sample testing methods using more than 200 ESG metrics by moving beyond the 'backtesting' approach, which suffers from hindsight bias, to evaluate ESG's investment potential.

It found that ESG information shows promise in traditional backtests with a 25% increase in Sharpe ratio - a metric in assessing risk-adjusted returns - in-sample, but the performance gains vanish when removing the benefit of hindsight on outperforming metrics.

There are also "dramatic" differences between out-of-sample and in-sample results, which suggest that ESG data may also introduce additional noise that can cancel potential benefits, Scientific Beta said.

The report suggests the optimal use of ESG information requires a tilt towards both ESG leaders and laggards, meaning ESG-informed investing "doesn't necessarily imply positive sustainability."

Additionally, alternative ESG metrics derived from systematic analysis is hugely influenced by traditional ratings, which challenges conventional ESG rating approaches.

Commenting, Scientific Beta research director Felix Goltz said the findings highlight the importance of subjecting investment strategies to out-of-sample testing.

"While ESG information may contain valuable insights, investors need realistic expectations about what can be achieved," Goltz said.

"Most importantly, any claims about the benefits of new investment metrics should be validated through proper out-of-sample testing rather than relying solely on traditional backtest frameworks."

Rather than dismissing ESG information, the study calls for more rigorous evaluation standards and realistic expectations about ESG's financial benefits, it said.