Morningstar - Q4 2021 - 46

Strategies
to investors that the firm is well managed and
has good governance structures in place. By
following socially responsible practices, firms with
a low ESG Risk Rating are assumed to be less
likely to be involved in adverse events, which
leads to reduced downside risk. Empirical studies
that support this hypothesis include Hoepner
et al. (2018) and Lööf and Stephan (2019).
Both have documented that better ESG firms are
associated with lower downside risk.
However, the findings in EXHIBIT 4-that stocks
with low ESG Risk Ratings had better returns
than high-rated stocks over this time-contradict
the popular hypothesis that higher risk should
be compensated by higher returns. If markets are
efficient, and investors properly incorporate
ESG risk into prices, future returns on stocks with
low ESG risk should be lower than on highrated
stocks. Ibbotson et al. (2018) proposed a
popularity asset pricing model in which
sustainable stocks are expected to underperform
in the long term because they are more popular.
Pastor, Stambaugh, and Taylor (2020) present
a specific asset pricing model for ESG investing
that proposes that both the expected return
and alpha for ESG stocks are lower than those for
non-ESG stocks; however, ESG stocks can
perform better than expected if ESG concerns
strengthen unexpectedly.
EXHIBIT 2
ESG Risk Rating Characteristics Stocks in quintiles with lower ratings are more
growth-oriented than stocks in higher-rated quintiles. Market caps are more mixed
across quintiles.
Equal-Weighted Average of Price/Book Ratios and Market Caps by Quintile
(August 2009 to November 2020)
Q1
(Lowest ESG
Risk Rating
Price/Book Ratio
Market Cap ($Million)
Source: Morningstar. Data as of 11/30/2020.
4.47
17,213
)
Q2
4.71
17,754
Q3
3.88
20,585
Q4
3.52
18,256
Q5
(Highest ESG
Risk Rating
3.04
12,340
)
In fact, literature on the performance of superior
ESG firms compared with inferior ESG firms
is mixed. Some studies show outperformance by
better ESG firms, some show underperformance,
and others do not provide conclusive results
(see Henriksson et al. [2019] for a brief literature
review). The bottom line is that results can
depend on the specific ESG rating methodology,
sample universe, and time periods.
One possible explanation of the findings in
EXHIBIT 4 is the secular trend of fund flows into
stocks with low ESG Risk Ratings, which drives the
prices of these stocks higher. Wigglesworth
(2020) reports that ESG-focused equity funds took
in nearly $70 billion in assets in just over one
year in 2019, while traditional equity funds suffered
almost $200 billion of outflows.
EXHIBIT 3
ESG Risk Rating Performance Stocks in the three lowest-rated quintiles
outperformed the two highest-rated quintiles. The differences between quintile 1
and 5 were stark.
Market-Cap-Weighted Performance of the Five ESG Risk Rating Portfolios
(August 2009 to November 2020)
Q1
(Lowest ESG
Risk Rating
Arithmetic Mean Return (%)
Geometric Mean Return (%)
Standard Deviation (%)
Sharpe Ratio
Skewness
Kurtosis
Max Drawdown (%)
Alpha (%)
Alpha T-Stat
Source: Morningstar. Data as of 11/30/2020.
16.32
15.14
14.51
1.08
-0.19
3.82
-18.86
0.33
0.32
)
Q2
17.00
15.87
14.09
1.16
-0.43
4.34
-20.95
1.32
1.27
Q3
17.48
16.33
14.20
1.19
-0.28
4.37
-20.04
1.82
1.74
Q4
13.47
12.21
15.12
0.85
-0.15
4.33
-23.25
-1.85
-1.44
Q5
(Highest ESG
Risk Rating
9.51
7.70
18.22
0.49
-0.38
6.86
-37.56
-3.79
-1.95
)
On the other hand, academic research provides
some evidence that ESG ratings have an
impact on fund flows. Ammann et al. (2019)
examine the effect of the introduction of the
Morningstar Sustainability Rating in March 2016
on U.S. equity mutual fund flows. They found
strong evidence that retail investors shift money
from funds with Low sustainability ratings
to funds with High ratings. They calculated that in
the first year after the rating launched, funds
with a High rating on average received between
$4.1 million and $10.1 million more in net flows
than funds with a sustainability rating of Average;
funds with a Low rating saw $1 million to $5
million less net flows than Average-rated funds.
Finally, Xiong (2021) provides more recent evidence
that ESG funds that hold sustainable stocks
have attracted significantly more flows than their
counterparts, which is associated with
the outperformance for both ESG funds and
ESG stocks.
46
Morningstar Q4 2021
Morningstar - Q4 2021

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