In an article for AdvisorPerspectives, Larry Swedroe of Buckingham Wealth Partners discussed the conundrum of ESG investing. In essence, the asset class is currently outperforming which many are interpreting as a validation of ESG’s promise. 

Yet, Swedroe contends that this conclusion is incorrect, since it doesn’t include the effect of increased inflows. In fact, a recent study from Norway’s oil fund revealed that non-ESG stocks actually delivered superior returns over a longer time period. One potential explanation is that inflows lead to increased valuations for ESG stocks, while it leads to depressed valuations for non-ESG stocks. 

Another explanation for the conundrum is that ESG stocks are less risky, because they on balance tend to have higher compliance standards and risk-management protocols. In the long-term, stocks with higher risk profiles tend to have better returns albeit with increased volatility. 

Companies with higher ESG scores also tend to be larger than companies with lower scores. This is another complicating factor as smaller companies tend to deliver higher returns over the long-term due to the risk premium. 

Overall, investors should understand that ESG outperformance is likely to be a short-term phenomenon due to the surge of inflows. Over the longer-term, the asset class could see lower returns due to a lower risk premium.

Finsum: ESG investing is booming, and many believe the asset class will continue to outperform. Larry Swedroe explains why it’s not so simple.