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  • Writer's pictureMiel and Uliana

Deciphering ESG Investing: Navigating Complexities and Cognitive Biases in Modern Finance

Environmental, Social, and Governance (ESG) investing has significantly evolved from its

roots in the 1700s to a major factor in today's investment decisions. However, with this

evolution comes complexities and can be impacted by a plethora of different components,

and can be significantly influenced by the halo effect in the context of ESG investing.

First, what does the halo effect mean, and how can it be applied to ESG investing? The Halo

effect is a cognitive bias that causes us to form a perception or judgement in one area based

on our decision about another one. For example, one is inclined to associate a physically

attractive person with other positive characteristics such as kindness and sociability. The

same principle can be present when an analysis of a company is performed. Multiple factors

are considered when company valuation is performed, and ESG performance is increasingly

important in forecasting a company’s future performance and value, especially among

socially responsible investors. For instance, actively managed ESG funds tend to add

companies that meet specific ESG criteria to their portfolios and exclude firms involved in

controversial activities.

Based on research into ESG investing, focus on ESG performance is associated with under

reaction to negative earnings surprises and other misplacing signals (Starks et al., 2020 in

Bofinger et al., 2022; Cao et al., 2020 in Bofinger et al., 2022). In general, investors'

preferences affect stock prices directly and indirectly. The direct effect is reflected in

companies with preferred characteristics associated with their fundamental value to be

associated with higher stock prices. At the same time, the indirect impact is reflected in

investors focusing on characteristics that are not directly connected to returns. This

“crowding out” effect of signals directly related to the fundamental firm value that predicts

returns can be associated with a focus on ESG.

Although the research conducted by Vanguard shows no consistent link between E, S, G, ratings-based stock selection and portfolio performance (neither negative nor positive), if the aforementioned stock analysis process is present in socially responsible investor’s stock selection methodology, it can lead to companies with high ESG performance being overvalued. Regression analysis performed by Bofinger et al. (2022) suggests that higher levels of sustainability are associated with fund overpricing.

Furthermore, the empirical data highlights a clear image of significant discrepancies among

ESG ratings provided by different agencies. The CFA Institute (2021) found correlations

ranging from 0.65 (between S&P Global and Sustainalytics) to as low as 0.14 (between ISS

and S&P Global). This variation can lead to unreliable information regarding the ESG quality

of firms, potentially confusing investment decisions and weakening the incentive for

companies to improve their ESG performance. The integration of regulatory technology

(Regtech) is becoming increasingly important in managing ESG data efficiently. The

proposed European Single Access Point (ESAP) by the European Commission is a prime

example, aiming to consolidate financial and ESG disclosures into a standardised system.

This integration facilitates better risk-data management and predictability, using the

micro-and macro-prudential regulatory framework.

Research into the correlation between ESG ratings and investment returns, such as the

study by Vanguard UK Professional, indicates a complex relationship. While these ratings

play a crucial role in investment decisions, the information feeding into these ratings, from

sources like LSEG (formerly Refinitiv), MSCI, and Sustainalytics, varies significantly. This

variance leads to a lack of consistent link between ESG ratings-based stock selection and

portfolio performance, suggesting that other factors also play critical roles in determining

investment returns.

The study 'Fund ESG Performance and Downside Risk' published in ScienceDirect

highlights three channels through which fund ESG performance impacts downside risk.

Better firm ESG performance reduces firm downside risk, but higher ESG ratings can lead to

lower portfolio diversification, increasing overall risk. This effect was particularly pronounced in the Chinese market, indicating regional variances in how ESG performance affects risk.

The world of ESG investing has transformed significantly over time, solidifying its

contemporary relevance, upping the anti for today’s investors, bringing with it complex

challenges. The halo effect, a significant cognitive bias, is something to be critical about

when integrating ESG factors into investment decisions, as it so often leads to misjudgments

such as overvaluation of companies with high ESG scores. This phenomenon, coupled with

the substantial discrepancies in ESG ratings across different providers, highlights the need

for a more standardised and reliable approach to ESG evaluation. The evolving role of

regulatory technology, especially initiatives like the ESAP, is paramount in harmonising ESG

data, thereby enhancing its reliability and usefulness in investment decision-making.

Furthermore, the varied impact of ESG performance on downside risk, particularly noted in

different regional markets such as China, emphasises the necessity of a nuanced

understanding of ESG factors in global investment contexts. Ultimately, while ESG investing

continues to grow in importance and influence, it is clear that navigating its complexities

requires a sophisticated, well-informed approach that balances ethical considerations with

sound financial judgement.


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