With the rise in socially responsible investing and quantitative strategies, are institutional investors that incorporate environmental, social and governance factors making markets less efficient and increasing mispricing signals?

The link between socially responsible investing and the efficacy of signals used by quantitative investors is explored in a new working paper by Jie Cao, associate professor of finance, Weiming Zhang, PhD candidate and Xintong Zhan, assistant professor of finance, all from the Chinese University of Hong Kong, as well as Sheridan Titman, a professor of finance at the University of Texas at Austin.

ESG investors that want to generate alpha are facing constraints, notes Zhan. “If you are socially responsible, you will be hesitant to pick up the dirty money, even if you think a company is cheap.”

This means a socially responsible investor may see a cheap company, know its price may jump tomorrow, but still won’t buy it, so the price may stay low even though it should rise.

The return predictability of quantitative mispricing signals is much stronger among firms held by more socially responsible institutions, the paper found. As socially responsible investors are less likely to buy underpriced stocks with bad ESG performance or sell overpriced stocks with good ESG performance, they react less to mispricing signals than other firms that aren’t constrained by ESG. This, in turn, affects stock price efficiency.

If socially responsible institutions are willing to give up some money because of ESG, other institutions, like hedge funds, may be able to take advantage of this, Cao says.

This can happen in the quantitative investing space, notes Zhan. “If a quantitative investor identifies that there is trading signal going on, and some of the investors, like socially responsible investors, are not reacting to that signal, it means the marginal value of that signal for quantitative investors will be larger. So [they] will be the ones to crack the mispricing and [they] will make more money out of it.”

Pension funds, and other socially responsible investors, will need to explain to plan members that because of their ESG preferences they may need to underperform using current asset pricing models, she says.

In the classic capital asset pricing model there’s no room for social preference, and it’s all about return and risk, notes Cao. “How can we incorporate [social] preference into a theory model? It’s very important. And maybe we can redefine the macro-efficiency using a new model.”

However, there isn’t a model available today that does this, he adds. “I think our paper provides some interesting evidence that would push for the researchers to come out with a new theory to explain our findings.”

Zhan says, at the end of the day, she’d like to see growth in socially responsible investing. “I think being green is our ultimate goal. Even though we show that market efficiency is affected. But I think this is a necessary step we have to take and that’s why we have to have the new models. The problem is not about ESG; the problem is that asset pricing models [are] not updated.”

The paper was presented by Zhan at the Northern Finance Association conference in September in Vancouver.