Thank God for Inefficient Markets

If markets were perfectly efficient, what would that mean for ESG concerns? No outperformance for sustainable stocks, according to Alex Edmans, Professor of Finance at London Business School.

“If a market was completely efficient, and didn’t take sustainability into account, then a sustainable company would trade at a premium, but then it wouldn’t actually deliver higher long-term stock returns because it’s already in the price,” Edmans said in a podcast hosted by Jason Mitchell, Co-Head of Responsible Investment at Man Group.

Fortunately, then, that the market is not efficient! Furthermore, many ESG factors remain non-quantitative, despite efforts to quantify the negative implications of environmental issues like climate change, or the positive implications and cost savings associated with adjusting supply chains to be more sustainable.

This is good news for investors: after all, if there was no financial incentive to invest in sustainable companies, at least one major driver for ESG investors would fall by the wayside.

It is also good news for discretionary managers. “If you are an expert in analysing profits and dividends and credit ratings and balance sheets, you might be outsourced to artificial intelligence one day, because for anything that is quantitative, you can have a smart-beta fund that invests on the basis of these criteria,” Edmans says in the podcast. “But something that can only be understood in terms of strategic context or something, like intentionality, that can only be discerned by meeting and talking to management – that’s something that I think active managers will always have a role in.”

This latter point is emphasised by Edmans in his most recent book ‘Grow the Pie: How Great Companies Deliver Both Purpose and Profit’¹, and which he expands upon in the podcast.

Interviewing company management has inherent drawbacks, Edmans says, since companies can cherry-pick examples of positive behaviour to enhance their image. However, this is no different to a job interview: candidates will always try to present themselves in the best possible light, but interviews allow us to gain key context into the bare facts of a CV. If we read ‘ESG metric’ for CV, the analogy holds – discretionary managers can glean valuable context to the bare bones of ESG ratings, enhancing their ability to profit from the failure of markets to efficiently incorporate sustainability into prices.

Comments may have been edited and condensed for editorial purposes.

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