Morningstar - Q4 2021 - 8

Dispatches
A World of ESG Views
and Preferences
Personalized portfolios
for all investors.
Phillips Curve
10
The Annuity ATM
Ivory Towers
12 How to Use Annuities in Retirement
Policy
15
Guaranteed Income for Retirees
Sustainability Matters
16
Bringing Structure to ESG
DEI
18
For Women, Issues Remain in Workplace
Global Briefs
21
31
Americas
Greater Europe
32 Australia & New Zealand
LETTER FROM THE BOARD
Thomas M. Idzorek and
Paul D. Kaplan
The topic of environmental, social, and governance
investing seems to be as polarizing as modern-day
politics. It evokes powerful emotions, making it
challenging for the different factions to find middle
ground, or to even hear one another at all.
At Morningstar, we are fundamentally data-driven
analysts and researchers striving to provide
unbiased analysis. One way we can analyze the
many facets of ESG is through the lens of an
emerging and rigorous theoretical asset-pricing
framework that embraces classical finance
as well as behavioral finance. As regular readers of
this magazine know, we call this the popularity
asset pricing model, or PAPM.1
Generally, investors approach ESG from one of two
perspectives: risk and return or values and
impact. Both views are valid, and the PAPM allows
for both. Importantly, they need not be mutually
exclusive. An investor's holistic perspective
on ESG is improved by trying to understand the
different views and their interactions.
Views on Risk and Return
From what is known as a pecuniary, or financial,
perspective, there is a wide range of disagreement
around how ESG impacts risk and return.
ESG Outperforms Without Superior Skill
This group of investors believes that ESG
investments will lead to superior risk-adjusted
returns, because ESG risks are systematically not
being properly reflected in asset prices to the
degree that it leads to exploitable levels of asset
mispricing. With this view, superior investment
skill is not necessary to exploit the mispricing. This
is the view of ESG evangelists.
ESG Outperforms With Superior Skill
This group believes that ESG investments can
lead to superior risk-adjusted returns conditional
on superior investment skill (perhaps aided by
superior information) in assessing ESG. Supporting
this belief is the thesis that the market is less
efficient at pricing ESG risks. As with other
forms of active management, one must have an
informational advantage or be better at
interpreting available information. This is the
view of ESG advocates.
ESG Performance Neutral
This group believes that ESG risks, like all risks, are
competitively priced, and to the degree that there
is some level of asset mispricing/market inefficiency,
it is difficult to produce superior risk-adjusted
returns. This is the view of ESG skeptics.
ESG Underperforms
This group believes that ESG investments will
lead to inferior risk-adjusted returns. It regards
ESG endeavors as a waste of money and resources
that do not improve expected cash flows. This
is the view of ESG detractors.
We should note that the track record and evidence
around easily exploitable opportunities, as well
as active management, do not bode well for the first
two risk and return views. Nor do they bode well
for the final view, as this would suggest one could
simply short stocks with attractive ESG attributes.
Millions of investors seek superior returns. Many
attempt to exploit any and all informational
advantages. This is a powerful force acting against
easily exploitable mispricing opportunities.
Values and Impact Preferences
Many investors have nonpecuniary values
and impact preferences that they want reflected
1 See Idzorek, T.M., Kaplan, P.D., & Ibbotson, R.G. 2021. " The Popularity Asset Pricing Model. " March 30. https://papers.ssrn.com/
sol3/papers.cfm?abstract_id=3451554
8
Morningstar Q4 2021

https://www.morningstar.com/authors/528/paul-kaplan https://www.nxtbook.com/nxtbooks/morningstar/magazine_20180607/index.php?startid=75#/p/74 https://www.nxtbook.com/nxtbooks/morningstar/magazine_20180607/index.php?startid=75#/p/74 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3451554

Morningstar - Q4 2021

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