WORKING PAPER

The ESG Integration Paradox

Michael Cappucci*1

If investment managers followed the old saying “whatever is worth doing is worth doing well,” then
more would have best‐in‐class environmental, social and governance (ESG) programs. It used to be that
asset owners could identify which investment managers “got” ESG investing principles simply by asking
whether they had a written ESG policy. Today, most investment managers have something to say about
ESG issues, and written ESG policies are becoming ubiquitous. Yet, as anyone who has ever looked at
investment managers’ ESG policies can attest, the existence of a written document is not a reliable
indicator of a firm’s commitment to or performance on sustainable long‐term goals.

Common sense would suggest that firms that devote the time and energy to developing an ESG
policy should want to get the greatest return for their effort. After all, why go to the trouble if you don’t
expect a return on investment? Surveys show that most investment management executives believe
that the right ESG strategy can provide a positive impact on long‐term investment performance. And in
most cases that means integrating ESG factors in the investment process in a way that mitigates ESG
risks and capitalizes on ESG opportunities.

Yet, actual practices with respect to ESG incorporation vary greatly, with most investment
managers falling well short of the gold standard of full integration. Perhaps not surprisingly, firms’
performance on ESG factors are approximately normally distributed, with most firms performing
somewhere around the mean, and only a few exceptional firms truly using ESG factors to deliver alpha.
Which creates a paradox: if the greatest benefits of ESG incorporation are achieved only through the full
integration of ESG factors into the investment process, why have so few investment managers adopted
the strategy? The data can’t tell us whether middle‐of‐the‐pack investment managers are experiencing a
positive or negative return on their ESG investments, but the concern lends credence to the skeptics’
worry that sustainable investing and the incorporation of ESG factors represent an unwanted distraction
from the main objective of delivering alpha. And for asset owners that rely on external managers to
manage their assets, whether they themselves are committed to sustainable investment principles or
not, the risk of negative ESG drag should present enough of a concern to factor into their own selection
process.

In what follows I lay out the case for an ESG integration paradox in more detail, and then offer
suggestions for asset owners seeking to avoid the worst‐of‐both‐worlds scenario of external managers
set up to absorb the costs of ESG integration without the promised benefits.

*1
Senior Vice President, Harvard Management Company, Inc., Boston, Massachusetts. © 2017

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The Gold Standard

More than forty years’ of academic and empirical evidence suggest that ESG integration in the
investment process can lead to better risk‐adjusted returns and long‐term value creation.1 And the gold
standard for sustainable investing is the full integration of ESG factors into the investment process.

There are as many ways to define ESG integration as there are managers trying to do it. Here, I
follow the definition of “Full ESG Integration” used by Robert Eccles and Mirtha Kastrapeli, working
under the banner of State Street’s Center for Applied Research: Investing with a systematic and explicit
inclusion of ESG risks and opportunities in investment analysis.2 Key to this approach is a commitment to
identifying and exploiting both ESG risks and opportunities.

In the early days of socially responsible investing, much of the focus was on using negative
screens to exclude companies in certain industries or sectors for moral or ethical reasons. Many asset
owners and socially responsible investment products still actively avoid investments related to tobacco,
alcohol and gun manufacturing, among others. These early efforts at ethically‐based investing produced
mixed (or worse) results. Over time, ethical investing became socially responsible investing (more
sophisticated negative screening), which morphed into thematic investing (e.g., the green tech boom in
the early‐to‐mid‐2000s) and eventually ESG integration. Within ESG integration, managers employ a
variety of ESG methods, ranging from active ownership/engagement, to positive screening (selecting for
certain attributes), to relative weighting (sometimes called “best‐in‐class selection”), to risk factor
investing, to full integration, with many managers employing multiple strategies either in combination
or tailored to particular asset classes or products.3 Full ESG integration reflects a wholehearted
commitment to the incorporation of ESG risks and opportunities in the investment analysis.

The case for full integration of ESG factors is supported by a number of recent surveys. Amir
Amel‐Zadeh of Said Business School, University of Oxford and George Serafeim of Harvard Business
School collected data from a survey of senior investment professions from conventional (i.e., not
explicitly socially responsible) asset managers. Respondents were asked whether they believed various
ESG strategies improve or reduce investment returns relative to a market benchmark. Full ESG
integration was the highest rated ESG strategy, with more than 60% of respondents believing that it has
a beneficial impact on investment performance.4 In a survey by the consulting firm ERM, 75% of
respondents thought that integration was key to ESG success.5 And Robert Eccles and Mirtha Kastrapeli
conducted parallel global surveys of institutional and retail investors and concluded that “only full ESG
integration has the potential to deliver on the goal of sustainable value creation for all investors.”6

Managers seeking to integrate ESG factors face a kind of J‐curve in which the majority of the
costs are borne up front, and the benefits are not realized, if at all, until well into the future. As the
intensity of ESG integration increases, the ESG drag on performance gradually decreases and eventually
flattens out and turns into a positive contribution as the benefits of ESG integration offset more and
more of the upfront costs. A 2006 study by professors Michael Barnett of the University of South Florida
and Robert Salomon of New York University suggests that the relationship between ESG integration and
investment performance is curvilinear, meaning that as the number of screens used by a socially

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responsible investment fund increases, the financial returns go down at first and then improve as the
number of screens increases and the stringency of the screening process intensifies.7

Before choosing and deploying an ESG strategy, investment managers need to carefully consider
both the relevant benefits and expected costs, because while the potential benefits are long‐term and
can be difficult to measure, the costs are immediate and real. They are competing against managers that
do not attempt to integrate ESG factors into their analysis and bear none of the costs of ESG integration.
Strategies that directly or indirectly employ exclusions must also choose from a smaller universe of
potential investments, thereby reducing the portfolio’s potential diversification and, by extension,
impairing the portfolio’s risk‐adjusted performance.8 Even strategies that do not negatively screen
investments incur the out‐of‐pocket costs associated with producing or acquiring and then analyzing the
relevant ESG data. The best case is that these costs are merely passed along to the underlying asset
owners and offset by improved financial performance. The worst case is that, if used ineffectively, they
can slow down, confuse or impede the investment process, and negatively impact performance.
Therefore, investment managers need to think long and hard about the type of ESG strategy they
pursue, because they don’t want to end up in the scenario in which their investors bear the costs of ESG
incorporation but fail to reap offsetting benefits.

The Paradox

Yet, the evidence suggests that that’s exactly where the majority of investment managers are in their
ESG performance.

The State Street survey by Eccles and Kastrapeli indicates that only 21% of institutional investors
use full ESG integration, either alone or in combination with other methods.9 This suggests that a
substantial percentage of institutional investors believe that full integration is the ESG strategy with the
greatest positive performance potential and also that it is not the best choice for their firm. (This
dissonance is perhaps less surprising to anyone who has ever tried to lose weight.) The result of the
State Street survey might be written off to the methodology of the study or as a quirk of the small data

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set were it not supported by a bevy of other research suggesting that a significant majority of investors
fall far short of the standard of full integration in their ESG implementation.

A survey by a trio of European researchers, Emiel van Durren, Auke Plantinga and Bert
Scholtens, found that, on average, the ESG scores of most asset managers are quite ordinary. Using an
online questionnaire to survey more than one hundred portfolio managers, they found that the average
self‐reported ESG integration score was 2.33 on a scale from one (no integration) to four (full
integration), with a standard deviation of 0.77.10 Most of the asset managers preferred to incorporate
ESG factors through modified research inputs such as ratings (45%) and company analysis (81%), as
opposed to unmodified raw data (30%), suggesting that ESG factors are not truly integrated in these
managers’ bottom‐up, fundamental analysis.11

This conclusion is also consistent with the results of a contemporaneous survey by the CFA
Institute, which asked its members: How do you take ESG issues into consideration in your investment
analysis/decisions? A reasonably impressive 57% of the respondents said that they integrate ESG factors
into the whole investment analysis and decision‐making process.12 But when asked how ESG integration
should be done, 72% of respondents either did not know how much should be spent on independent
verification of ESG reporting or thought that it should be less than one‐quarter of the cost of the audit of
the financial statements, and only 28% indicated that they receive training on the consideration of ESG
factors.13 Besides the item for ESG integration, the responses for the other ESG investment strategies
were strikingly similar, and generally within the surveys’ respective margins for error, suggesting that
while a majority of CFAs incorporate ESG factors into their investment analysis in some way, most of the
time integration is discretionary and unsystematic, without equal emphasis on identifying ESG risks and
seizing ESG‐related opportunities.14

When MSCI rated the ESG quality of a universe of mutual funds and ETFs, the results followed
an approximately normal distribution pattern, with the majority of equity and fixed‐income funds scored
by MSCI ESG Research earning median scores, and 99% earning an ESG Quality Score within three
ratings points of the mean.15 Beyond the realm of asset management, most scoring of ESG performance
follows an approximately normal, or bell‐shaped, distribution. For example, MSCI’s ESG scores of
companies in its public company database are distributed approximately normally both globally
(represented by the MSCI World Index) and across countries and sectors.16

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 These findings are broadly consistent with my experience in the field. Having spoken with
dozens of asset managers and asset owners about ESG issues, many are doing something to consider
ESG factors in their investment processes. But apart from the publicly‐listed behemoths and a select
group of SRI boutiques and ESG true believers most US asset managers are operating well short of the
ideal.

Possible Explanations

There are a number of possible explanations for the ESG integration paradox. First, no one ever said that
integrating ESG factors was easy. There are a number of obstacles to full integration, from data quality
to measuring standards to debunked but long‐held views about negative impacts on financial
performance. Perhaps more troubling are concerns about the misalignment of ESG’s long‐term benefits
and firms’ short‐term performance incentives. The apparent paradox could also be the result of the
informal (or lack of) methodology in the comparison of ESG integration intensity and performance.

There are a number of direct barriers to full ESG integration. In their study, Eccles and Kastrapeli
asked respondents to identify the most significant barriers to ESG integration. (Again, respondents were
allowed to select more than one option.) Their research showed that the greatest barriers to ESG
integration are the lack of standards for measuring ESG performance (60%) and the lack of ESG
performance data reported by companies (53%). Other obstacles included concerns about under‐
performance (47%) and cost (34%).17 Similar results were found by Amel‐Zadeh and Serafeim when they
asked their respondents to identify the impediments to ESG integration. Lack of comparability across
firms (44.8%) was the most frequently identified impediment, followed by lack of reporting standards
(43.2%), cost (40.5%), data usefulness (39.4%), lack of quantifiability (37.8%), and lack of comparability
over time (34.8%).18 All of these factors, and no doubt many more, present obstacles to even the most
well‐intentioned investor’s efforts to fully integrate ESG factors in their investment process.

Some portion of the lag between actual ESG practices and full integration may be due to timing.
The US investment community began recognizing the value of ESG integration only relatively recently,
and it may be some asset managers are on their way to full integration but their plans are yet only
partially implemented.

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 A deeper worry is that while asset managers may know intellectually that full integration is the
best strategy for ESG incorporation, their incentives are out of alignment. Investment performance is
still typically measured on 1‐, 3‐ and 5‐year time horizons. Forty‐seven percent of asset owners and 43%
of asset managers that participated in the State Street study indicated that they believe that the proper
timeframe for expecting ESG integration to deliver outperformance is five years or more, but only 10%‐
20% use these time frames for evaluating performance.19 The dominant practice is still to base
employee compensation on annual performance measures. These concerns led Barnett and Salomon to
conclude that the market fails to accurately price long‐term initiatives with extended payoff periods.20

The ESG integration paradox relies on a compilation of results from a number of scientific
studies and voluntary surveys over a roughly ten‐year period. It may be that we simply await another,
better study that will show that the relationship between ESG intensity and financial performance is
linear, in which there is no paradox at all. Or it may be that the premise underlying the paradox—the
comparison between ESG performance and risk‐adjusted financial performance—is invalid.

Implications for Asset Manager Selection

An ESG integration paradox poses a particular set of challenges to asset owners. If the relationship
between the intensity of an asset manager’s ESG efforts and its risk‐adjusted performance were
classically linear, then ESG performance would correlate directly with financial performance. However,
the data suggest that more ESG incorporation does not always lead to better risk‐adjusted returns. So
how should asset owners use ESG information to evaluate asset managers?

The key is to look for managers that are on the upward slope of the ESG intensity curve. These
are managers that have survived the growing pains of the early stages of ESG integration (the downward
part of the curve), but that have not yet reached the final stage where ESG performance and long‐term
financial performance converge. (Once ESG factors are fully integrated into an investment manager’s
investment process, any positive contributions to financial performance should be fully reflected in the
manager’s 5‐ and 10‐year performance figures.) Two indicators of managers on an upward ESG
trajectory are positive ESG momentum and strong intentionality in their investment approach.

Rather than absolute ESG performance, a better indicator of future investment gains is positive
ESG momentum—ESG scores that are average but improving. A study conducted by NN Investment
Partners and the European Centre for Corporate Engagement found that companies with average ESG
scores that have positive momentum made the biggest contribution to Sharpe ratios.21 Firms with high
ESG scores did not experience improved financial performance, likely because these factors were
already reflected in the firm’s financial performance. However, rising ESG scores improved risk‐adjusted
returns across the board.22

Another key factor in judging firms’ behavior is the intentionality of their ESG commitment.
Some firms are great at producing glossy brochures and colorful sustainability reports, but fall short
when it comes to the hard work of integrating ESG considerations in their business processes. According
to Jeroen Bos of NN IP, “Intentionality addresses the question of whether companies actually intend to
do good through their products and solutions and through the way they operate in society.”

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Intentionality is perhaps the best indicator of a firm’s commitment to a long‐term, sustainable business
model. It is demonstrated by a firm’s tone at the top, employee training, and resources spent on ESG
research and data.

Unlike alpha, the yardstick for measuring conventional asset management performance, there is
no mathematical formula for measuring a manager’s ESG performance. However, smart asset owners,
using the right tools and asking the right questions, can use ESG factors to help identify those
investment managers who will deliver the strongest risk‐adjusted returns over the long run.

1
Eccles, Robert G. and Kastrapeli, Mirtha D., “The Investing Enlightenment.” Accessed May 2017.
http://www.statestreet.com/content/dam/statestreet/documents/Articles/The_Investing_Enlightenment.pdf.

See also, Melas, Dimitris, Nagy, Zoltán and Kulkarni, Padmakar, “Factor Investing and ESG Integration.” [Nov 2016]
Accessed May 2017. https://www.msci.com/www/research‐paper/factor‐investing‐and‐esg/0528147089.

2
Eccles and Kastrapeli [2017].

3
Amel‐Zaheh, Amir and Serafeim, George, “Why and How Investors Use ESG Information: Evidence from a Global
Survey.” Working paper, accessed May 2017. http://www.hbs.edu/faculty/Pages/item.aspx?num=52392.

4
Id. (Because respondents were allowed to rate more than one strategy, the results add up to more than 100%.)

5
ERM, “The recipe for ESG success.” Private Equity International [Feb 2017].

6
Eccles and Kastrapeli [2017].

7
Id.

8
Barnett, Michael L. and Salomon, Robert M., “Beyond Dichotomy: The Curvilinear Relationship Between Social
Responsibility and Financial Performance.” Strategic Management Journal, Volume 27, number 11 [Sept 2006].

9
Eccles and Kastrapeli [2017].

10
van Duuren, Emiel, Plantinga, Auke, and Scholtens, Bert, “ESG Integration and the Investment Management
Process: Fundamental Investing Reinvented.” J Bus Ethics, 138:525‐533 [March 2015].

11
Id.

12
Orsagh, Matt, “CFA Institute Survey: How Do ESG Issues Factors into Investment Decisions?” [2015] Accessed
May 2017. https://blogs.cfainstitute.org/marketintegrity/2015/08/17/cfa‐institute‐survey‐how‐do‐esg‐issues‐
factor‐into‐investment‐decisions/. Like the State Street study, the CFA Institute survey allowed respondents to
select more than one option.

13
Id.

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14
I am borrowing here from the “Discretionary” approach described in “How Investors Integrate ESG: A Typology
of Approaches” by the IRRC Institute and Sustainalytics. Accessed May 2017. https://irrcinstitute.org/reports/how‐
investors‐integrate‐esg‐a‐typology‐of‐approaches/.

15
Moen, Eric, “MSCI Introduces ESG Quality Scores For Mutual Funds, ETFS.” [March 2016] Accessed June 2017.
https://www.msci.com/www/blog‐posts/msci‐introduces‐esg‐quality/0308840040
16
Melas, Nagy and Kulkarni [Nov 2016].

17
Eccles and Kastrapeli [2017].

18
Amel‐Zaheh and Serafeim [2017].

19
Eccles and Kastrapeli [2017].

20
Barnett and Salomon [2006].

21
Bos, Jeroen, “Sustainability Scores for Investment Funds.” CFA Institute Magazine [March 2017].

22
Id.

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