Material ESG Alpha: A Fundamentals-Based Perspective

Can sustainability yield alpha, or is outperformance merely explained by fundamentals?

Byung Hyun Ahn, Panos N. Patatoukas, and George S. Skiadopoulos revisit the claim that firms that improve on material ESG issues deliver abnormal returns in their paper "Material ESG Alpha: A Fundamentals-Based Perspective".

They replicate this observation using U.S. stock data and the Sustainability Accounting Standards Board framework, then control for traditional accounting fundamentals to see if the ESG outperformance persists.

Their conclusions include:

• This study confirms a baseline "ESG alpha" already observed in prior research, showing companies with rising scores on material sustainability issues outperformed with about 0.22% of extra return per month (~2.6% annually).
• ESG-improving firms tend to be economically stronger: larger, more profitable, slower-growing, and overall more mature businesses.
• After controlling for fundamentals like profitability and growth factors, the apparent sustainability alpha vanished and the ESG-improvers portfolio no longer beat the market.
• The authors constructed a "fundamentals-only" portfolio ignoring sustainability scores of large, slow-growth, profitable firms. It achieved virtually the same returns and overall sustainability rating as the actual sustainable portfolio.
• State Street's R-Factor dataset (indices aligned with the SASB framework) showed no persistent outperformance compared to mainstream benchmarks after adjusting for style factors.

This paper shows that companies that boost their material ESG ratings often have the classic traits of stable, well-established firms known to drive solid stock performance. If a sustainability-themed fund claims to beat the market, it may just be favouring already profitable and stable companies eligible even without a sustainability label. This analysis however focuses on the specific approaches of SASB's framework and MSCI's ratings, and the measurement of ESG improvements is relatively coarse (tracking discrete rating changes). While it shows fundamental traits explain the returns of ESG improvers, it doesn't prove causality: both signals could stem from a third factor like high management quality.