Andy Kern, Senior Portfolio Manager, New Age Alpha Jan 17, 2021 7:30:00 AM 22 min read Academic Research

New Age ESG Investing - Avoiding the losers: Environmental, Social, Governance AND Financial


Popular ESG investment strategies have traditionally been at odds with outperformance. This is due to their construction and a focus on companies that are not truly conscious of environmental, social and governance issues. Instead, many build broad portfolios, eliminating only a small subset of the universe. This encourages the proliferation of “green washing,” or the practice of labelling a product as environmentally-conscious while only paying cursory attention to the field. Additionally, little regard is given to the attractiveness of the stock price, causing many overpriced but good ESG companies to be selected. We outline a process by which only the best ESG companies can be selected and the portfolio is able to outperform due to a unique stock selection process within this limited universe.


Environmental, Social and Governance (ESG) investing approaches have soared in popularity in recent years. Fund managers seeking to do societal good have embraced such approaches, but often do so at the expense of their investors. While evidence suggests ESG strategies can produce outperformance, the implementation of such strategies has heretofore been flawed.

ESG is a new field of asset management and is the progeny of what was previously called “socially responsible investing (SRI).” SRI tended to work by excluding companies with certain product lines or operating in certain industries from the universe simply because such things were deemed to be undesirable. In contrast, ESG investing often takes an inclusive, rather than exclusive, approach to portfolio construction, looking at companies more holistically and evaluating on much more nuanced dimensions.

There are plenty of theoretical reasons to suspect that companies with strong ESG characteristics may perform better in the future than those without. For example, an environmentally conscious company that makes large investments in alternative energy sources may realize energy cost savings in the future. The academic literature is replete with evidence that better corporate governance practices result in improved profitability and returns, dating back to the seminal work of Jensen and Meckling (1976). Moreover, mitigating business risks associated with poor ESG practices may improve corporate image and branding. It stands to reason that companies meeting certain ESG guidelines may help the investor outperform.

Unfortunately, theory and practice often diverge. Many investment strategies in this burgeoning market niche have underperformed the broad market, leaving investors frustrated (see Auer and Schuhmacher (2016)). The investment community is in need of an ESG product that can both outperform as well as satisfy environmental, social and governance objectives.

On June 23, 2020 a significant proposal was issued by the Depart of Labor (DOL) which will, if adopted, place far more responsibility on ERISA plan sponsors when making ESG investment decisions. According to DOL Secretary Eugene Scalia, "Private employer-sponsored retirement plans are not vehicles for furthering social goals or policy objectives that are not in the financial interest of the plan."1

1“U.S. Department of Labor Proposes New Investment Duties Rule,” News Release, June 23, 2020, Employee Benefits Security Administration, U.S. Department of Labor.

This means, simply, that if a plan sponsor wishes to make an ESG investment, it must first establish that the investment is appropriate with the ESG component notwithstanding. Accepted measures of risk and return must be weighed appropriately as they would for any other type of investment. Using ESG criteria does not relieve the sponsor from the fiduciary responsibility it has to the beneficiaries of the plan to focus on pecuniary factors.

One problem with most ESG approaches is the conflicting manner in which ESG decisions must be made while simultaneously focusing on returns If the portfolio manager is seeking market-beating returns, he or she must sometimes relax the ESG standards so as to avoid narrowing the universe of stocks by too much.

We believe New Age Alpha’s ESG investment approach will allow investors to engage in responsible ESG investment without sacrificing returns or abandoning proper risk/return analysis.

On the Performance of ESG Strategies

Until recently, evidence on the performance of SRI strategies in the academic literature was inconclusive. However, the meta-analysis of Fulton, Kahn and Sharples (2012) was able to disentangle the impact of ESG strategies from the much larger category of SRI strategies. This research concluded that firms with a higher ESG rating have a lower cost of capital and generally do outperform on both a financial and accounting basis. This provides hope that, at least in theory, an ESG strategy will provide both societal benefit and returns.

Nevertheless, it does not yet appear that most investors are benefiting from the relation between ESG and returns. Although fund flows into ESG products continue to rise, this is ostensibly not the result of the products’ performance records but rather an appetite for such strategies from investors.

One such example is one of the largest ESG ETFs, the iShares ESG MSCI USA ETF. While its performance does outpace its universe, the difference is small.

Annualized Performance ESG MSCI USA ETF (ESGU)

The investment objective of this fund is to “track the investment results of an index composed of U.S. companies that have positive environmental, social and governance characteristics as identified by the index provider while exhibiting risk and return characteristics similar to those of the parent index.” That is to say, the companies in the fund have similar risk and return characteristics to the universe, so the portfolio should, to the extent ESG selection produces alpha, outperform. Yet the outperformance is not very convincing. We believe this is due to two distinct, but related drivers.

First, in an effort to outperform and provide the manager with a wider selection universe in which to find undervalued stocks, the ESG standards of the portfolio may be relaxed so as to prevent the universe from being narrowed too much due to ESG concerns only.

Second, such strategies can result in a so-called “growth trap.” We believe, as more investors shun poor ESG companies in favor of better ESG companies, the better group is more prone to becoming overvalued. As a result, good ESG companies will appear to perform well when in reality the performance is an illusion caused by investor crowding.

How Wide a Net Should the ESG Manager Throw?

Strategies that use methods of exclusion rather than inclusion are far more likely to select stocks of companies that, while not doing anything particularly objectionable, may not have exemplary ESG qualifications either. Traditional SRI methods were exclusionary in nature. Methods of exclusion include, for example, automatically disqualifying companies in specific industries such as tobacco or controversial weapons. Further exclusions can be entirely subjective, even with prejudice against specific companies.

This can result in a portfolio of stocks with common characteristics. As stocks are excluded from the universe, the universe that remains will be less diverse. While this clearly impacts the diversification tactics of the manager, it also entices the manager to be less discriminating with respect to ESG, possibly accepting stocks for consideration that are only mediocre in terms of environmental, social or governance issues.

What exactly is ESG?

Another issue facing the ESG investment landscape is the lack of any standard definition of what qualifies a company or stock on the basis of ESG. Calling it “aggregate confusion,” Berg, Koelbel and Rigobon (2019) show that the major data providers often diverge significantly in terms of the ESG ratings they assign stocks. The resulting lack of clarity, therefore, makes it difficult for the prices of such stocks to reflect the true ESG characteristics of the firm. It also creates difficulty for the investor receiving mixed signals from the data providers.

Too many asset managers have benefitted from this imprecise definition of ESG investment to the detriment of their investors. While some managers have pure motives, we believe far too many either have critical blind spots in their methodologies or rely on firms practicing “green washing”— misleading consumers about the amount of environmental responsibility they bear – resulting in traditional Smart Beta strategies that the manager can claim is environmentally or socially conscious. We believe ESG investment demands just as much rigor and precision as any other investment theme. If done correctly, we believe a quantitative structure that avoids human behavior risks can generate performance comparable to non-ESG options while still investing in responsible corporate citizens.

The market needs a product that is truly ESG and that can truly produce returns. At New Age Alpha we believe we have a solution to this need. It comes from harnessing the performance potential of ESG itself while relying on New Age Alpha’s Human Factor methodology to reduce the risk of human behavior.

New Age Alpha’s Human Factor Methodology

The central pillar of New Age Alpha’s investment philosophy is that stock prices are affected by human behavior. Unlike most investment firms, we don’t fear ignorance—we embrace it. In the framework of a rigid, quantitative methodology, we accept that flawed, illogical human behavior is not just a part of the stock market, but a function of it. And then we avoid such behavior. Rather than attempting to predict what stocks might be winners, we’ve created a quantifiable means that we believe avoids the losers. While some market information is easily interpreted, we believe the very nature of opinions and beliefs results in information that is vague and ambiguous. And then, when such information is combined with additional human behavior bias, it gets interpreted in systematically incorrect ways. Mispricings result and the market begins to look more like a roulette table than the efficient price-discovery machine many claim it to be.

We believe our investment philosophy works across asset classes, geographies and over time. Our core belief is that stock prices are affected by human behavior, creating a risk that erodes alpha even though investors aren’t compensated for taking it. We codified this risk in a quantitative methodology. It is called the Human Factor.

Using a probability-based approach to stock selection, we help investors identify and avoid the Human Factor. We believe a result is outperformance that is not attributable to commonly accepted risk metrics utilized by many investment managers. Rather, we measure a company’s ability to deliver the growth implied by its stock price in order to determine the Human Factor. A low score means there is less risk that is the result of human behavior, and that the company is likely to deliver. A high score represents more of this risk resulting from human behavior and, thus, represents a riskier investment. We do not guess or make predictions of the future. The methodology is entirely quantitative and probability-focused, stripping out the noise and clatter of the market.

We believe the Human Factor methodology will deliver reliable, market-beating returns. This is achieved by, rather than seeking to guess winning stocks, actively avoiding stocks likely to be losers. In order to guess a winning stock, the analyst must have information about the future. Yet the future is unknown and uncertain. Thus, we believe that avoiding high Human Factor stocks allows us to avoid losers. This process integrates well a process of ESG inclusion.

New Techniques Needed

In building an ESG portfolio, New Age Alpha seeks to benefit from both the Human Factor methodology as well as strict ESG criteria. This combination of approach creates opportunity for investors. We work with data provided by Refinitiv in the ESG selection process, and so it is important to understand how Refinitiv arrives at its ESG Scores. With over 150 content research analysts who are trained to collect ESG data, Refinitiv has one of the largest ESG content collection operations in the world.

Refinitiv calculates ESG scores in an effort to objectively measure a company’s “commitment and effectiveness” as it pertains to environmental, social and governance matters. It uses more than 400 company-level ESG criteria, to evaluate each company. The result is the three Pillar Scores and the Overall ESG Pillar Score, which is a reflection of a company’s ESG profile.

And what about the definitional problems confronting ESG investment? As noted earlier, the lack of standardization is one of the headaches confronting investors, above and beyond the level of performance that may be sacrificed. But within ESG investment itself lies a disparity in measurability, as well. Traditionally, when one mentioned the term, “ESG,” it was often associated with, “Sustainability.” And though some might even use the terms interchangeably, they are certainly not the same thing. A result of this association, though, was a greater emphasis being placed on the, “environmental,” and, “social,” portions of the acronym, to the detriment of the, “governance” portion. This connotation also had roots in the data utilized. Generally speaking, it’s often easier to measure a company’s environmental and social impact than it is to track their governance efforts. On a basic level, oil companies can be screened out easily. And, delving deeper, a company who has faced litigation regarding environmental issues won’t be able to hide. Social Governance is often more promissory, however, and the data analyzed can be misleading. Virtually all companies have some form of Code of Conduct and Policy for Fair and Ethical Work Standards, but the actual enforcement of the policies is key—and likely not captured by traditional ‘box-checking’ ESG reporting.

Some industry leaders have already coined a term for this inclination, referring to it as, “The 80/20 Governance Trap.” (Hedstrom (2019)) The theory posits that ESG Evaluation Firms may be able to measure 80 percent of the environmental and social impacts of a given company. However, they can only capture 20 percent of governance criteria, at best. If one believes such an assertion, this is a huge blind spot in ESG investment.

We believe our strategies can bridge the gap for investors via our Human Factor methodology. A low Human Factor score means the stock has less risk human behavior impacting returns. The score is not affected by internet rumors or hype—it focuses solely on a company’s ability to deliver the growth implied by its stock price. As such, this quantitative approach often reveals companies that, “have their house in order,” so to speak. In the previous example, the Human Factor may not show the enforcement of the Code of Conduct, but it will have a strong correlation with those firms who have enacted a responsible, efficient corporate culture.

In particular, Refinitiv’s Overall ESG Pillar Score seems to identify losing stocks by use of ESG criteria with little to no correlation with Human Factor score. In the table below we break the universe into quintiles on the basis of ESG Score. While the top four quintiles have very similar return profiles, the lowest quintile – those stocks with the worst ESG characteristics – performs noticeably worse. This implies that by focusing on the best ESG stocks we may be able to avoid the losers within the ESG universe.

Characteristics ESG Pillar Score Quintiles

The losers in the ESG universe are likely different than losers identified by Human Factor. Poor ESG Scores indicate that the company will be susceptible to firm-specific shocks. Poor Human Factor scores indicate that the company is unlikely to deliver the growth implied by its stock price. In other words, each is identifying something different.

In results not shown, we calculate the correlation coefficient between Human Factor score and ESG Score. It is only 0.051, essentially indistinguishable from zero. Thus, a combination of Human Factor score and ESG Score could be complimentary because each is identifying something different.

Beware of a “Growth Trap”

Investment in ESG strategies has surged in 2019 and 2020—there is little doubting this fact. What this implies for the actual companies and their prospects for continued future performance remains very much in question, however. For one, due to the aforementioned dilemmas in a standard definition of ESG investment, this definitional vaguery introduces problems when comparing the performance of competing firms or products. More insidiously, however, some contend this also introduces a “growth trap” regarding the investment performance of such strategies.

A “growth trap” is classically defined as a correlational vs. causational dilemma. For example, an investor may see a company’s stock increasing in value and believe, therefore, that it’s a good investment because it will continue to grow. The potential “trap” occurs when there’s a disconnect between an investor’s expected growth and the growth that has already been priced into a stock by the market itself. It’s not enough for a company to grow; it must grow faster than the market has already priced. For the overall ESG sector, the question becomes: is it currently performing well on its merits or is this performance a temporary self-fulfilling prophecy that will eventually end?

At NAA, we don’t take a stance on whether ESG investment is currently a “growth trap.” We don’t need to. Our philosophy specifically avoids human behavior that leads to such mispricings. We prefer to avoid the losers, first and foremost in a bottom-up fashion, before ever getting concerned about top-down “growth traps.”

Putting it All Together

Our approach to ESG portfolio construction aims to avoid the pitfalls discussed earlier. Our inclusionary method of selection will permit only the best ESG companies to be included. And working with Refinitiv ensures that all companies are evaluated based on objective rules rather than manager subjectivity.

New Age Alpha, working with S&P Dow Jones, publishes the New Age Alpha US Large Cap ESG Index. This index will serve as the basis for some New Age Alpha ESG offerings. We start with the universe defined by the Refinitiv United States Total Return Index. From these approximately 600 stocks, we narrow the selection universe only stocks with a Refinitiv ESG Score greater than 75. This results in approximately 130 stocks, although this can change as the ESG scores of companies shift. Note that this procedure allows us to focus on only very strong ESG companies.

We know that the Human Factor selection system can produce outperformance and we have strong theoretical reasons to expect the ESG selection system to do the same. At the same time, we know that Human Factor scores and Refinitiv ESG scores are uncorrelated and calculated entirely independently. We therefore create a combined ranking of the approximately 130 stocks by first ranking on the basis of Human Factor, then separately ranking on the basis of ESG Score, and averaging the two rankings. Once completed, the top fifty stocks by this combined ranking are included in the portfolio.

However, because we believe stocks with the most attractive Human Factor scores have the least risk resulting from human behavior, we feel confident weighting the portfolio by market capitalization. We believe the inclusionary method of combining the Human Factor with Refinitiv’s ESG Scores ensures a unique selection method that avoids growth traps even as a market weighting mechanism ensures the portfolio will perform and be responsive to the market overall.

In the table and chart below, we display the index performance of the New Age Alpha US Large Cap ESG Index and the S&P 500 ESG Index. It is clear that the performance of the New Age Alpha US Large Cap ESG Index far exceeds that of the S&P 500 ESG Index. This should satisfy investor appetite for both alpha and ESG.

NAA US Large Cap ESG and S&P 500 ESG Index

Hypothetical Growth of $1000

This chart represents a hypothetical $1000 investment. This chart is not intended to imply any future performance. Please see disclosures for important additional information.


The ability of ESG products to produce alpha may soon be of significant interest to the Department of Labor. This is a critical departure from previous standards and ERISA plan sponsors, as well as other fiduciaries and RIAs, will be forced to navigate the changes carefully. In essence, they will be de-incentivized from recommending ESG strategies unless a compelling case can be made regarding a strategy’s ability to generate alpha.

Our ESG strategy is fully integrated, rather than utilizing mere “inclusion / exclusion” criteria. We believe one can invest responsibly without sacrificing performance. By working with Refinitiv, we’ve created an industry-exclusive design that combines their ESG Scores with our Human Factor scores in a synergistic fashion. The result is a strategy that enables ESG investment while, from a performance perspective, is also conflict-free for plan sponsors and other fiduciaries. Our ESG strategy doesn’t merely reward good stewards of the earth, it also avoids the investment losers.

At New Age Alpha we strongly believe that performance and responsible investment do not need to be de-coupled. When pursued intelligently, we believe one can complement the other. New Age Alpha’s CIO, Julian Koski, is passionately driven by his love for nature and recognizes the responsibility to preserve it for future generations. Julian built and owns Kubili House, a luxury safari lodge in South Africa’s Greater Kruger National Park. He believes that people want their travel dollars to serve a greater purpose and that aligning the interests of owners, tourists and local communities is a key to sustaining our natural resources.


Auer, Benjamin and Frank Schuhmacher, 2016, “Do socially (ir)responsible investments pay? New evidence from international ESG data,” The Quarterly Review of Economics and Finance 59, 51-62.

Berg, Florian, Julian Kölbel, and Roberto Rigobon, 2019, “Aggregate Confusion: The Divergence of ESG Ratings,” MIT Sloan Research Paper No. 5822-19, August 20, 2019.

Fulton, Mark, Bruce Kahn and Camila Sharples, 2012, “Sustainable Investing: Establishing Long-Term Value and Performance,” Deutsche Bank Climate Change Advisors.

Hedstrom, Gilbert, 2019, “Beware the 80/20 Governance Trap: Focus on the ‘G’ in ESG,” The Conference Board.

Jensen, Michael and William Meckling, 1976, “Theory of the firm: Managerial behavior, agency costs and ownership structure,” Journal of Financial Economics 3, 4, 305-360.


New Age Alpha refers to the New Age Alpha separate but affiliated entities, generally, rather than to one particular entity. These entities are New Age Alpha LLC, New Age Alpha Advisors, LLC (“New Age Alpha Advisors”) and New Age Tau, LLC. Investment advice is offered through New Age Alpha Advisors, LLC a wholly owned subsidiary of New Age Alpha LLC.

New Age Alpha Advisors is an investment advisor registered with the U.S. Securities and Exchange Commission. New Age Alpha Advisors, located in the State of New York, only transacts business in those states in which it is properly registered or qualifies for an applicable exemption or exclusion from such state’s registration requirements. You cannot invest directly into an index.

Past performance is not indicative of future results. Current and future results may be lower or higher than those shown. Therefore, no current or prospective client should assume that the future performance of any specific investment, investment strategy (including the investments and/or investment strategies recommended and/or purchased by New Age Alpha), or an Index, product, or strategy made reference to directly or indirectly in this firm overview, will be profitable or equal to corresponding indicated performance levels. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio. Historical performance results for investment indexes and/or categories generally do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment management fee, the incurrence of which would have the effect of decreasing historical performance results. Unless otherwise noted, returns for one year or less are not annualized, but calculated as cumulative returns.

No client or prospective client should assume that any information presented in this overview serves as the receipt of, or a substitute for, personalized individual advice from New Age Alpha or any other investment professional. Any charts, graphs or tables used in this firm overview are for illustrative purposes only and should not be construed as providing investment advice. Information contained herein does not reflect the actual performance of New Age Alpha’s products or portfolios. All research and data is simulated and should not be considered indicative of the skill of New Age Alpha. The research data presented has been calculated by applying each Index strategy backwards in time and is not a contemporaneous record of actual assets managed by New Age Alpha. The New Age Alpha ESG Indices are designed to be socially responsible investment benchmarks. The New Age Alpha ESG policies could cause it to make or avoid investments that could result in the portfolio underperforming, similar indexes, portfolios or funds that do not have an ESG Policy. More information about the New Age Alpha ESG methodology is available upon request.

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