ESG Investing

ESG Ratings: A Compass without Direction

Topics - ESG Investing Portfolio Risk and Performance

${ numberSection } ${ text }
ESG Ratings: A Compass without Direction

ESG ratings firms provide information to investors, analysts, and corporate managers about the relation between corporations and non-investor stakeholders interests. Recently, ESG ratings providers have come under scrutiny over concerns of the reliability of their assessments. In this Closer Look, we examine these concerns. We review the demand for ESG information, the stated objectives of ESG ratings providers, how ratings are determined, the evidence of what they achieve, and structural aspects of the industry that potentially influence ratings. Our purpose is to help companies, investors, and regulators better understand the use of ESG ratings and to highlight areas where they can improve. We find that while ESG ratings providers may convey important insights into the nonfinancial impact of companies, significant shortcomings exist in their objectives, methodologies, and incentives which detract from the informativeness of their assessments.

We ask:

  • Why do ESG ratings often fail to meet their stated objectives? Is it due to methodological choices these firms make, or the sheer challenge of measuring a concept as broad and all-encompassing as “ESG?”

  • Are fund managers properly motivated to ensure ESG ratings are reliable in predicting risk and performance? What steps do they take to validate ratings before using them?

  • Despite their weaknesses, do ESG ratings have a role to play in reporting and compliance purposes?

  • Would more expansive corporate disclosure improve the quality of ESG ratings? Is it even possible for companies to disclosure the vast number of stakeholder-related metrics that feed into ESG ratings?

  • Should the SEC establish policies, procedures, and protections to reduce conflicts of interest and improve market confidence in the quality of ESG ratings?
 

Published in

Stanford University’s Closer Look Series

AQR Capital Management, LLC, (“AQR”) provide links to third-party websites only as a convenience, and the inclusion of such links does not imply any endorsement, approval, investigation, verification or monitoring by us of any content or information contained within or accessible from the linked sites. If you choose to visit the linked sites, you do so at your own risk, and you will be subject to such sites' terms of use and privacy policies, over which AQR.com has no control. In no event will AQR be responsible for any information or content within the linked sites or your use of the linked sites.
 

The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AQR Capital Management, LLC, its affiliates or its employees. This information is not intended to, and does not relate specifically to any investment strategy or product that AQR offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. Past performance is not a guarantee of future results.

 

Hypothetical performance results have many inherent limitations, some of which, but not all, are described herein. The hypothetical performance shown was derived from the retroactive application of a model developed with the benefit of hindsight.  Hypothetical performance results are presented for illustrative purposes only.

 

Diversification does not eliminate the risk of experiencing investment loss.

 

Certain publications may have been written prior to the author being an employee of AQR.

This material is intended for informational purposes only and should not be construed as legal or tax advice, nor is it intended to replace the advice of a qualified attorney or tax advisor.

 

AQR Capital Management is a global investment management firm, which may or may not apply similar investment techniques or methods of analysis as described herein. The views expressed here are those of the authors and not necessarily those of AQR.