ESG for Institutional Portfolios

Abstract

This white paper examines Environmental, Social, and Governance (ESG) issues in the context of institutional portfolios that include alternative investments, such as private equity, hedge funds, and real assets. We also examine ESG as an expression of the broader concept of stakeholder capitalism. The goal of the paper is to provide a framework for understanding issues related to ESG investing through an objective lens grounded in theoretical and empirical economic analysis. We summarize a large body of academic research on ESG and consider how these results might apply to risk and return in institutional portfolios and specific alternative investments. We also propose a new model for evaluating potential nonpecuniary benefits related to ESG characteristics that provides for evaluating trade-offs in ways consistent with fiduciary responsibility. Our conclusions suggest that much of the popular narrative around both pro-ESG and anti-ESG viewpoints is not well-informed by theory or evidence. In particular, we document that ESG factors do provide value-relevant information to investors, but the effects on asset returns and valuations are modest. Furthermore, investors should expect long-run returns to be lower on average for investments that rate well on ESG criteria. Rapidly evolving ESG reporting considerations create ambiguities that are magnified in the alternative investment space because of more limited information on private companies. One practical conclusion of our analysis is that expectations for ESG measurement and reporting should be “right-sized” to fit smaller companies and investment firms because of the potentially large data collection and reporting costs. Overall, we emphasize that investor expectations and regulatory requirements should carefully consider the cost-benefit tradeoffs to ESG mandates for alternative investment vehicles.

Authors

This report derives from the work of the Institute for Private Capital’s Research Council and academic researchers affiliated with UNC Kenan-Flagler, The Kenan Institute of Private Enterprise, and the Institute for Private Capital. It draws on an extensive analysis of ESG and stakeholder capitalism conducted by the Kenan Institute available here. A list of contributing authors is available as an appendix.